How Professional Investors Create Portfolios of Undervalued Stocks
Some of the greatest investors of our time have been known to find stocks at a bargain to generate large returns over time: Warren Buffett, Phil Fisher, and John Templeton come to mind. While the task is by no means easy, creating a portfolio of undervalued stocks can be a good way to potentially earn higher returns, as undervalued stocks may be priced lower than their intrinsic value and have the potential to increase in value as the market recognizes their true worth. However, finding undervalued stocks can be challenging because it requires requires careful analysis, the right tools, and patience. In addition, investments sometimes don’t pan out like people think, and it’s easy to fall into value traps (thinking there is value where there really isn’t).
Here are some steps you can follow to create a portfolio of undervalued stocks:
Research companies: Start by researching companies that you are interested in investing in. Look for companies with strong financials, such as consistent revenue growth, a healthy balance sheet, and a track record of profitability. John Templeton always said that you should focus on the future of a company, not just what it’s doing in this very moment.
Analyze financial statements: Look at the company's financial statements, including its income statement, balance sheet, and cash flow statement, to get a better understanding of its financial health and performance. Look for red flags, such as declining revenues or increasing debt, that could indicate that the company is not performing well. For most investors, financial statements are a barrier to entry because it requires some proficiency in accounting to understand.
Compare the stock's price to its intrinsic value: Use financial ratios, such as the price-to-earnings ratio (P/E) or the price-to-book ratio (P/B), to determine if the stock is undervalued. If the stock's price is lower than its intrinsic value, it may be considered undervalued. However, keep in mind that earnings can be calculated in a variety of ways, so you can’t just use one method and call it a day. Cash flow is just as, if not more, important.
Consider the company's industry and macroeconomic conditions: Consider the company's industry and the broader economic conditions. A company may be undervalued due to temporary setbacks or challenges that are specific to its industry, rather than due to fundamental problems with the company itself. Betting on the macro environment has proved all but impossible, and many businesses are phased out over time; this is particularly true of the tech sector. Thus, it’s important to consider monetary policy, fiscal policy, and secular trends when choosing your investments.
Diversify your portfolio: It’s not enough to know one specific industry. It's important to diversify your portfolio to spread risk across different types of assets and industries. Consider including a mix of undervalued stocks, as well as other types of investments, such as bonds, real estate, and cash.
Remember that investing carries risk, and it's important to carefully consider your risk tolerance and investment goals before making any investment decisions. It's always a good idea to seek the advice of a financial professional before making any investment decisions. At Park 64 Capital, we set up portfolios with strong fundamentals to help investors reach their long-term goals.
