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Greg Speicher
Greg Speicher
Articles (62) 

10 Reasons Why a Stock Can Be Undervalued

July 20, 2009

If you find a stock that you believe is undervalued, it is important to try to determine the reason for the undervaluation. As Buffett wrote about poker in his 1987 letter to shareholders, "If you've been in the game 30 minutes and you don't know who the patsy is, you're the patsy."

Interestingly, some value investors, such as David Einhorn of Greenlight Capital, invert this process. Rather than first looking for undervalued stocks based on quantitative screens, for example, low multiples of price to earnings or price to book value, they first identify areas of the market where undervaluation is likely to be present and then search for good companies within that undervalued sector.

When Buffett purchased shares of the Commonwealth Trust Co. of Union, New Jersey, he indentified the reason that was largely responsible for the depressed price of the company's stock. It was because the company was not paying a cash dividend. Identifying this reason reduced the probability that there were other unknown or poorly understood reasons why the stock price was depressed which could have materially reduced the intrinsic value of the company and lead to a permanent loss of capital.

When I attended the Value Investing Executive Education course at Columbia, in June of 2007, our professor, Bruce Greenwald, stressed the importance of asking yourself, when you’ve identified a great bargain, why the market is making it available to you at such a great price. If you can't answer the question, perhaps there are people on the other side of the trade who know something you don't or who are smarter than you. This is why it also makes sense to look carefully at who else has taken a position in the stock or who has not taken a position in the stock. For example, it may be meaningful to observe that, even though newspaper stocks are selling at extremely low multiples, Warren Buffett and Rupert Murdoch have not stepped in and made purchases. What does it tell you when two of the savviest and knowledgeable media investors in the world have passed on stocks that you may deem to be a great value? This is not in opposition to the idea that an investor needs to do his own independent thinking. It is just another fact in the investment appraisal and a recognition that others may have access to more or better information than you do.

Here is a partial list of reasons a stock may be undervalued:

1. The General Market is Down - This is generally the most obvious reason that a stock is undervalued and occurs when the macro view of the economy is poor. It is useful for investors to have some basic tools to value (not predict) the general market so they can prepare as the market becomes undervalued.

2. The Macro View about a Particular Industry is Poor - A classic example of this was in the 90's when the prospects of "Hillarycare" took down healthcare related stocks.

3. The Macro View about a Particular Geographic Area is Poor - In the 1990-1991 recession, California's economy was in bad shape after its real estate market suffered a large decline. This set-up a great opportunity in Wells Fargo's stock which Buffett took advantage of.

4. There is a Severe Short Term Problem which does not Damage the Business Franchise - The classic examples here are Buffett's purchase of American Express after a financial scandal in 1963 and his purchase of Geico in the late 70's after it severely underpriced its insurance risk. In both cases, the problems could be fixed and, more importantly, they did not damage the competitive advantage of American Express's brand and Geico's low-cost structure.

5. The Company has Diversified away from its Core High-Return Business - In the 1980's, Coke diversified into non-core low-return businesses such as shrimp farming and movie making which masked the gold mine they had in the core soft drink franchise. In 1988, when Buffett began to accumulate Coke at around fifteen times earnings, the stock was not overly cheap based on traditional valuation metrics, but this unwise diversification masked the degree to which the market recognized that Coke was a long-term wealth generating machine.

6. The Company Does Not Pay or Has Cut its Dividend - Buffett cites this as the reason that Commonwealth Trust Co. was undervalued when he bought it in 1958. It probably also contributed to the sell-off in high yield U.S. regional banks as they cut their dividends in 2008 to build their capital bases.

7. The Company is Not Followed - If a small company has little or no analysts following the company it may be undervalued because it is neglected. Nobody is getting paid to follow the stock and cheer it on.

8. The Company is a Spin-Off - This is another classic opportunity area. The new company may have excellent economics and prospects which were not understood or appreciated when it was part of its parent company. Joel Greenblatt's book You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits provides a great overview of spin-offs.

9. The Company is Emerging from Bankruptcy - The market fails to recognize the value of a newly organized company free of its heavy debt burden or other legacy problems.

10. The Company is Too Complex - This is a favorite area of famed value investor Seth Klarman. If most investors don't understand a given situation or they are unwilling to do the amount of work involved, it may make an undervalued situation available to astute value investors.

About the author:

Greg Speicher

Rating: 3.6/5 (36 votes)


Greg Speicher
Greg Speicher - 11 years ago    Report SPAM
Please comment on other situations where you have found undervalued stocks. If I get enough, I can compile them into another article on the subject. Thanks.

Batbeer2 premium member - 11 years ago
The classic bust of a commodity cycle.

Chipmakers and mining companies come to mind. After the industry is flooded with excess production capacity, the lowest cost producer may find itself underpriced due to (temporary) margin compression.
Value_barbarossa - 11 years ago    Report SPAM
I think right now a similar situation can be found among MLP's that temporarily cut or eliminate distribution to pay down debt.

These units are usually help only for the income, and the institutions that hold them seem to be selling indiscriminately if the dividend is cut.

I find it similar to the "spinoff" effect that Greenblatt talks about, because basically a bunch of people are left holding units that they don't want anymore (the people who usually hold MLP's hold them for large income payments) and will sell regardless of IV.

I actually view the distribution cuts as accretive to IV over time on these overleveraged MLP's as well, because they can bring leverage within reason (and away from fear of loan covenant issues) and fund growth CapEx from cashflow (rather than the credit line).

Eventually after these companies have shored up their balance sheets, they will reinstate distributions and should sell for a lot more (even in today's market where this sector is arguably undervalued [or overvalued...that's why you look for the margin of safety])
PlanMaestro - 11 years ago    Report SPAM
This is the list I follow to search for opportunities:

Dividend Cuts (EROC), Spinoffs (TKTM), Index Changes (ACLS), Emergency from Bankruptcy (Lear), Sector Jinxed (FRX Healthcare), Failed M&As (Hausmann), Year End Effects (all the MLPs in December), Stocks below 5, Complex Amortization/ Depreciation/Growth Accounting (SSW, URI), Reverse mergers to become public (GSL) Credit Crises.

Robert Sprinkel
Robert Sprinkel - 11 years ago    Report SPAM
Staying mostly with MLPs, though it may b e true for regular corporations, I think there is an 11th point. Last year, I thought it was a positive for companies, MLPs in particular, to have institutional support/investors. Missing from my analysis was the fact that MLPs, again in particular, are not as volatile as regular companies. During the panic days of the crash, hedge funds (no mutual funds own MLPs) sold their best, least volatile investments, MLPs, to meet redemptions.

I now look at institutional (read hedge fund) investors as a negative in evaluating an MLP. I now see that insider ownership, previously ignored, is a positive for MLP investors. This does not mean that I won't invest in an MLP that does not have strong insider support. There are not some very good MLPs that have relatively little in the way of insider investment. But, as a long-term investor, I am now very wary of major institutional investment. On an unweighted basis, the 15 MLPs in my portfolio are 25.71% owned by institutions and 27.81% owned by insiders.

If the economy is in slow-down mode as some think and inflation is on hold while the world de-leverages, then it is incumbent on MLP and, I think, all investors to find those companies that have a minimum of long-term debt unless it is secured by hard assets (TOO, TGP, KSP). It may be interesting to watch a company pay down its debt, but it is even more interesting to see the dividends coming into your account rather than watch what would have been "your" dividend paid to the banks. Peter Drucker's wisest statement, or so it seems to me, is in his book "Managing for Profits". He said, "Once you have solved a problem, you are only back where you should have been in the first place. Therefore concentrate on your opportunities and not on your problems."
Value_barbarossa - 11 years ago    Report SPAM
Robert Sprinkel,

Thanks for the post. I just have one question (or comment rather).

You say "It may be interesting to watch a company pay down its debt, but it is even more interesting to see the dividends coming into your account rather than watch what would have been "your" dividend paid to the banks."

This basically goes 100% contrary to my approach on MLP's which is to try to find the best value possible (OK...that's my approach for everything). Well the problem is that right now EVERYONE wants high dividend payers with no debt. They're not attractively valued in comparison to some of the semi-distressed counterparts.

However, when you look at a company like BBEP or EROC (I agree with Plan Maestro that this is one of the best right now) cuts its distribution, EVERYONE sells regardless of the fair value. The result is that I'm able to pick up an MLP that should LONG term be paying about a 40% dividend yield. It's got too much debt, but because of the dividend cut that's getting paid down.

Have you thought about the potential of buying UNITS of an MLP like EROC around $3.50, and then try to think of what the price will be when debt is reduced and distributions resumed? IMO if EROC pays off $200-$250 million in debt, and then resumes the $0.36 MQD the share price is going to be close to $10 even in a weak environment.
Batbeer2 premium member - 11 years ago
... It may be interesting to watch a company pay down its debt, but it is even more interesting to see the dividends coming into your account...

This I have never understood. If a company pays out dividends, your stake in the business becomes worth less. If the company has a lot of debt, the company was not worth a lot in the first place. So.... dividends do not come into the value equation. You are just getting something that belonged to you in the first place.

Don't get me wrong, if a company can't reinvest that cash in a meaningfull way, IMO the right choice is to pay out the cash to shareholders. But the fact that a company is paying a dividend does not add to it's value. Don't get me started on taxes.
Greg Speicher
Greg Speicher - 11 years ago    Report SPAM
Thank you for discussion on MLPs.

PlanMaestro, thanks for your list of opportunity areas.

Batbeer2, I generally agree with your comment on dividends. An investor should focus on what Buffett calls Owner Earnings when valuing a company (GAAP Earnings + Depreciation/Amortization - Maintenance CapEx). Dividends are generally a subset of this, but in some cases the company cannot cover the dividend and has to resort to debt or dilution to keep it going. Provided a stock is not overvalued (and better yet undervalued), buybacks return value to shareholders in a more tax efficient manner. Better yet is if the company can retain its earnings and reinvest them at a high rate of return. Many high ROE companies simply cannot retain all their earnings and reinvest them at a high ROE. Berkshire Hathaway is an exception that comes to mind and is one of the reasons (along with its access to insurance float at essentially no cost) for its tremendous success in growing both book value and intrinsic value over the past 40 years.

PlanMaestro - 11 years ago    Report SPAM
I am going to ruffle feathers, but I believe that leverage is part of the value equation when you have STABLE cash flows. If you can juice your ROE increasing your leverage WITHOUT COMPROMISING the sustainability of the company that is part of the competitive equation. Media and newspapers were the usual example, but fixed contract long haul pipelines, chartered shipping companies, hedged MLPs are other examples.

However, when I invest in that kind of companies I much rather get dividends than reinvestment and growth. Given the high ROE juiced by leverage, those are sectors prone to over investment and bubbles specially when there are no barriers to entry. So I much rather invest alongside management that is more conservative with the uses of cash flow given the aggressiveness of it sources (just check commercial real estate)
Buffetteer17 premium member - 11 years ago
batbeer2: "The classic bust of a commodity cycle."

This makes me think of AMAT, which I've been studying recently. They make the machines that make silicon chips. Obviously they're highly cyclical and right now at the bottom of a cycle. This business has some relationship to commodities because anyone can make these machines (although the startup cost is rather high), there is little moat.

AMAT's price has been beaten down to around $12, because their sales and profits have plummeted. Their E is so bad, they have an astronomical forward P/E of near 50. But that's classically the time to buy commodity-like stocks, since they're sure to recover, just don't know when. Looking at the free cash flow per share over several years, it is around $2.25. They're sitting on a mountain of cash with no debt. Figuring $4 for the cash/share and giving the cash flow a 10x multiple, we're looking at a $25 stock. Historical margins are high, for example ROE of 17% and operating margin of 21% over 5 years, including the disasterous 2008.

I'm reluctant to pull the trigger for one reason. The book value has not been growing over time. It is about the same now as in 2001. Since they pay only a small dividend, you'd think with that cash flow and those margins, they'd be piling up book value. I guess more detective work is needed to see where all those profits actually went...
Batbeer2 premium member - 11 years ago
>> I believe that leverage is part of the value equation when you have STABLE cash flows.

Fair point.

>> If you can juice your ROE increasing your leverage WITHOUT COMPROMISING the sustainability of the company that is part of the competitive equation.

There are many ays to get a better ROE. IMO, adding debt is not the most meaningfull.

BRS for example has taken on a lot of debt in order to grow... at least that is what they say and as far as I can tell, that is what they are doing. AYR, same thing.

If I can understand what the debt is being used for, I have no problems with debt; but the simple matter of juicing your "paper" ROE by adding debt, in general, does not apeal to me. Let alone adding debt to pay dividends.
PlanMaestro - 11 years ago    Report SPAM
So don't you think Microsoft would not be a more valuable company if they issue AAA debt and use cash and FCF to pay dividends and buyback stock at current prices? The capital structure matters and has been the foundations of several successful LBO firms.

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