To make money as a value investor, you have pay less than what a company is worth. An ability to value a business is the anchor that makes that premise hold true. And since valuation is not an exact science, you have to invest with a margin of safety. While getting into the specifics of valuation is beyond the scope of this article, one way to isolate potentially undervalued securities is to buy the stocks that other investors hate.
TUTORIAL: Stock Basics
Buying What the Crowd Sells
Stock prices are ultimately a function of supply and demand. Greater demand relative to supply will cause prices to rise and vice versa. When the financial crisis hit in late 2008, there was virtually no demand for stocks and prices were undeniably attractive. Today, the mood is vastly improved and, as a result, there aren't many cheap stocks floating around. Whatever opportunities abound, investors are likely to find them where few others are looking. Occasionally, you get boring large caps like Dell (Nasdaq:DELL) that offer opportunity to those with patience. Dell shares trade at 8 times forward earnings - at one time during the tech boom, the P/E was over 50. Sure, Dell may never grow as much as it has in the past, but to buy a business with a 40% unlevered return on equity for 8 times earnings may be a great deal that is currently being overlooked by investors.
In Need of a Little Polishing
There is little demand these days for anything real estate related. That might explain why shares of Builders FirstSource (Nasdaq:BLDR), a supplier of construction materials to commercial builders, are not popular. But while this company's numbers may not look good today, that is precisely when the best valuations can appear. The company is trading for around $2 a share, or $200 million. Net debt is $97 million. There are no profits yet to speak of, but sales are stabilizing. The success of BLDR rests on the resumption of housing starts. Real estate is clearly bottoming out, and even the slightest improvement could send shares significantly higher well before homebuilders see any improvement. And since BLDR deals with homebuilders, it does not compete with Home Depot (NYSE:HD) or Lowe's (NYSE:LOW). Management has curtailed capital expenditures and is managing the business accordingly. (For more, see Economic Indicators: Housing Starts.)
Financials are getting sold off again and shares in Wells Fargo (NYSE:WFC) are starting to look attractive again. At $27 a share, WFC is far above the recession lows of $9 a share, but at the current price, the stock is trading for 8 times forward earnings. That's a very attractive multiple for a banks that is widely considered to be one of the best-managed U.S. banks.
The Bottom Line
Buying what others are selling is a very difficult process and one that requires the courage to go it alone. Doing so, however, can provide above-average investment gains. After all, if your thesis proves correct, you will have made a profit before most other investors even get on board.
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