Everybody loves a bargain, and every investor loves undervalued shares. It’s the dream scenario. I pick up a stock that the market has overlooked, and reap the rewards when the market catches onto its potential.
When hunting for undervalued shares, private investors have one big advantage over the professionals. Nobody is judging our performance. We don’t have to publish regular reports, justifying our investment decisions. Or explain why we have underperformed the market.
That means we can afford to be more patient, and buy stocks that could take some time to recover. Then hang on until they do.
Cheap doesn’t mean cheerful
Buying undervalued shares does not mean buying cheap shares. All too often, stocks are cheap for a good reason. Investing in undervalued shares means buying high-quality companies at prices that do not reflect their long-term growth potential.
It may be an unloved business, or a business in an unloved sector. Last year, for example, the banking sector was out of favour as pandemic lockdowns hit revenues and profits. Now it’s in demand, as investors position for the recovery. Lloyds Banking Group is up 65% in just six months, Barclays is up 85%. These shares don’t look so undervalued now.
In theory, buying undervalued shares offers a wide margin of safety. Not always in practice, though. Some might say cinema chain Cineworld Group was undervalued last year. But I don’t think it was. Its rock bottom valuation reflected the existential threat it faced from the pandemic and streaming services. Anybody who bought it had to accept they could lose all their money.
I didn’t buy it but others spotted a great value opportunity, and have been rewarded. Cineworld is up an incredible 269% in six months. As you can see, what qualifies as an undervalued share is very much a matter of opinion. We only know for sure with hindsight.
I like buying undervalued shares
I considered FTSE 100 insurer Legal & General Group to be undervalued for several years, but the market disagreed. When I last reviewed it in January, it was trading at just 8.22 times earnings and yielding 7%. Now it is finally coming good, up 53% in six months. I had to be patient, though. Again, this share doesn’t look so undervalued now, trading at 13.44 times earnings.
When seeking out undervalued shares, I like to read annual accounts to find out the firm’s financial strength and management strategy. I weigh the short-term challenges against the long-term investment opportunity. Figures such as the price/earnings ratio come in handy.
Investors in undervalued shares should look to build a balanced, diverse portfolio. Some stocks may never recover their lost potential. Others will, but will take their time about it. With luck, one or two will fly. Spreading my risk soothes my nerves while I wait for my strategy to come good. In this case, patience is the ultimate virtue.