What Should I Look For in Bargain Stocks?

Don’t we all wish that we had bought Apple Computers (NASDAQ:AAPL) in 2003 for $7/share (currently touching $400/share) or my all time favorite, Hansen Natural (NASDAQ:HANS) that could be bought for 50 cents/share just 8 years ago and now currently sells for $80/share!

These stocks were bargains in the hindsight but if you were investing then you would have not known just by looking at them.  Of course, no one knows the future and it would not have been possible to predict the launch and success of iPhone and iPads back then.  And if, in 2003, someone had told you that a maker of fruit juice drinks is going to be the hottest stock of the decade, you would have just laughed.

There are many such stocks today that are selling at a bargain price.  Some of these stocks will go on to deliver spectacular performance for the investors who have done their due diligence today and patiently hold on for a long time.  The question is how we find them.  Let’s see if we can answer the question “what should I look for in bargain stocks?”

Using Traditional Valuation Measures Should be the First Step

Many of these investments that eventually work out very well start their journey from the bargain bin.  Apple Computers was just a floundering computer manufacture, a has been and the only question at that time was how long the company could continue to survive.  It had seen many quick CEO changes and was having difficulty getting software makers to write software for Mac.  Nobody wanted to touch the stock with a 10-feet pole.  Hansen Natural was one of the countless micro caps selling packaged drinks in an already saturated market.

These 2 companies were cheap and could have shown up on many of the traditional valuation screens such as Price/Earning or Price/Book.  But if you find 100 undervalued stocks in this way, you still do not know which ones are going to be stars and which ones will be duds.

Good News for the Lazy – It May not Matter

Research shows that if you restrict your stock research to just finding low P/E stocks (such as P/E ratio below 12) or low P/B stocks (such as P/B ratio below 1), and create a diversified portfolio of such stocks with 20 or more stocks in your portfolio, you will beat the market over long term.  If that is the extent of your research, you will still come out ahead of 70% of all the mutual funds in the US.  Some of your stocks will be spectacular failures, some others will be great successes but by just introducing that bias of undervaluation in your portfolio you will be guaranteed that your successes will far outperform your failures.  Professor Greenwald, Columbia University, talks about this in quite detail in his book on value investing (Value Investing: From Graham to Buffett and Beyond).

But You are Not Lazy and You Can do Better

The trick to improving your performance, and lessening your risk of picking duds in your portfolio is actually quite simple.  Know the company and the business you are buying stock in.

If you knew Apple, you probably knew Steve Jobs, and you also probably knew how loyal Mac users were (and still are) to Apple products.  The catalyst for Apple stock was Jobs taking up the CEO reigns again at the company.  Apple created a niche for itself based on creativity, aesthetics and engineering, and Jobs brought that culture back to Apple along with the passion that only he can bring.  Similarly, if you knew that Hansen was locking up retail agreements with Costco and other large retailers you might have viewed the company differently.

Knowing the management and their commitment to the long term value creation is that one intangible that the numbers can’t quantify and investors are very likely to miss.

Understanding the business will also tell you if the stock is a value trap.  Yes, Airlines are probably cheap and so are the newspaper stocks.  But a vast majority of the companies in these sectors are not good investments just for the fact that these sectors are either dying or low margin/unprofitable sectors.  But you know what, there are still some companies in these sectors that are profitable and can reward investors.  So how do you find a Southwest Airlines (NYSE:LUV) among a sea of red that is characterized by US Air, United and their ilk?  There are no two ways about it, you will have to do your research in the company and its business.  Often times, a good company in a bad sector will prosper as the competition slowly disappears.

Need More Reasons to Research a Company?

Sometimes a stock with a very high P/E ratio might actually be very cheap.  Why?  Think of a company that just incurred a large one time cost that wiped off most of its profits.  Perhaps, a legal settlement of some kind or a product recall, or a failed new product launch.  In any case, if you know that the company is fundamentally sound and will recover from this temporary problem, you will be fully justified in thinking the stock as a bargain and buying into it.  There is a behavioral aspect to investing, and most investors, including funds, have a tendency to imagine the worst when a temporary problem arises.  This is when a good value investor spots an opportunity.

Numbers alone do not make a stock a bargain.  Take some time to do research on the company and understand what they are all about and you just might find some bargain stocks to grow your portfolio.

About the Author: Shailesh Kumar, MBA writes about value investing at Value Stock Guide where he researches and finds bargain stock picks for fun and profit!