Even the best companies fall out of favor from time to time. You may be able to acquire shares of these companies at a fraction of their intrinsic value. To do so, you will need to determine which companies are permanent losers and which are undervalued gems.
The following four questions can help you make that determination:
1. Is the Company's Problem Temporary or Long-Term?
You should not invest in a company simply because everyone else is running from it. Sometimes there is a reason to run, and the stock of such companies may not be worth buying at any price.
In certain circumstances, though, problems arise due to isolated incidents. For example, during the Savings and Loan ("S&L") Crisis in the 1980s and 1990s, the share value of many banks spiraled down to almost comical levels. Banks boasting a solid balance sheet, established reputation, top-notch management, and steady customer base were hit just as hard by the crisis as banks of lesser quality. Any investor who mentioned at the time that they were purchasing shares of any such banks would have been immediately scorned and mocked.
Even so, certain investors relied on their analytical judgment to purchase shares in certain banks during the crisis. Years later, these investors were able to reap the benefits of their purchase. It is your responsibility as an investor to analyze a company and its problems to determine whether the undervaluation of its shares is longstanding.
2. Is There Suitable Market Capitalization?
When assessing which companies to invest in, focus on those that are non-asset- intensive businesses with high returns on equity and little to no debt. Companies that operate in non-commodity type industries without fixed cost structures should be preferred.
You should also look for undervaluation in larger rather than smaller companies. As an example, in the event of a retail recovery, large retailers such as Walmart will likely be able to get back on their feet sooner than small specialty retailers such as Tuesday Morning. The shareholders of small-specialty retailers may have to wait considerably longer for their shares to realize their full value in the market than shareholders of large retailers.
3. Does Management Have an Excellent Track Record?
If a company has encountered significant problems for consecutive years while the industry in which it operates prospers, the source of the company's struggles may lie with management. In such cases, take special care about purchasing shares based on promises or explanations offered by the company's executives.
Great management tends to produce great results for everyone involved, including shareholders. Coca-Cola provides an excellent example of how effective management can make a great company even better. Coca-Cola performed well for decades, but it was not until Roberto Goizueta stepped in as chief executive officer in 1980 that the company became a global powerhouse. To the benefit of shareholders, Coca-Cola was able to buy back some of its shares of common stock and, in doing so, leveraged significantly higher earnings for the remaining shares.
The quality of a company's management may be the most important factor you consider before purchasing that company's shares. Keep in mind, however, that past results do not necessarily guarantee future performance.
4. Are You Financially Able to Wait Out the Storm?
After you have determined that the company's problem is temporary, that there is potential for suitable market capitalization, and that management has an excellent track record, you need to assess whether you are financially able to wait out the company's troubles. What are the odds you will be forced to sell your shares to meet another obligation?
If there is even the slightest chance you may need to have a forced sale to get cash in light of a personal need, you should not try to acquire the undervalued shares. Even if the purchase appears to be a wonderful investment opportunity, you will be gambling with your money if you do not have the luxury of waiting for the company's intrinsic value to be reflected in the share price. While any good company will eventually be recognized by the market, you can't predict when. The moment you fail to make that distinction, you are no longer an investor, but a speculator.
In the short run, anything can happen. There is nothing to stop an undervalued stock from falling significantly further in price. You must have the time to wait for the inevitable result of wise investing—whether it takes weeks, months, or years. In the end, sound analytical judgment and unshakable patience should be handsomely rewarded.