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UNDERVALUED
STOCKS

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UNDERVALUED STOCKS

What are Undervalued Stocks?

There is no shortage of investor definitions as to what constitutes a value stock. An undervalued stock is a stock that has a market price that is well below its fair value. The main idea behind investing in undervalued stocks, or value investing, is that the market occasionally misprices a stock. The cause of this misprice can be a number of things; however, the following are the most common:

• Lack of investors’ confidence

• Company’s fundamentals improve rapidly, but the market has not factored yet those changes

• Consensus estimate

A value investor expects that the market will eventually recognize the mispricing and correct it, thereby eliminating the divergence.

Value Stocks vs. Value Traps

The idea of a value stock is that it is somehow undervalued by the market and is worth more (in value) than its price. Hence the terminology “undervalued stocks”. The approach we take is to spot these undervalued stocks before the market does, invest in them and then wait, the idea being that eventually the market will come around and see there is indeed “more value” in these value stocks, and as a result will bid the prices up. As a value investor you should sell when the price rises to the level where the stock is no longer a value and move on to find new value stocks. You must be aware however that many cheap stocks are cheap for reason and often only get cheaper. These stocks are known as “value traps”. They appear as a good bargain because of their low prices, however, they perform horribly in the market. No matter how cheap they are, those value trap stocks get cheaper by the minute. Usually, at some point, an event triggers and investors realize that these stocks were never really cheap because of their value being lower than their prices. That event may be a bad quarterly earnings announcement, an investigation into questionable accounting practices, an unexpected loss of a major customer, the recall of the flagship product or the unexpected entrance of a well-financed new competitor into the company’s primary market.

Being able to distinguish between true value stocks and value traps is what separates successful value investors from unsuccessful ones.

The Opportunity

Undervalued stocks are typically a great purchasing opportunity because their value is much higher than their current price which increases quickly presenting investors with the ability to turn a profit. For this reason, undervalued stocks are usually considered a good investment for stock market traders.

What Happens to Undervalued Stocks?

A most likely outcome is that the market will become aware of its undervalued stock. This will lead to more purchases from new investors which will drive the market price up. As the stock’s value increases, it will draw further attention from investors who might choose to invest for other reasons. Eventually, the market price of the stock will be equal to or greater than its fair value. Once this occurs, the investors who purchased the stock when it was undervalued may choose to sell the stock for a profit.

Another possibility for undervalued stock is a complete sale of the company to a competitor or a new business in the given industry. Acquisitions like this are purchased at a premium to the market price; however, investors will sometimes hold on to the stock in the hopes that the company’s shareholders will fight for a larger offer. If the shareholders push and win a better offer, the investors of the undervalued stock gain a larger profit than if they had accepted the original offer; however, regardless of the route the acquisition goes, a profit is gained.