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Raiders of the lost stocks
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May 21, 1998: 10:19 a.m. ET
Smarts and a desire for exploration are necessary for value investors
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NEW YORK (CNNfn) - They are hidden in dark, shadowy recesses and can be more valuable than gold. Men have gone mad searching for them. These treasures are undervalued stocks.
Undervalued stocks are the prize of a  particular breed of investor. Value investors believe the market is not necessarily always efficient at pricing stocks.
Some stocks, they say, may languish at an undervalued price even though the company's fundamentals are sound.
Conversely, value investors believe one day the overall market will appreciate these once-hidden treasures, sending the stock price up, garnering fame and fortune for the value investor.
Not everyone is up to the task of searching the remote corners of the market for undervalued stocks. But into this temple of doom step men like Bob Davis, editor of the Napeague Letter, a newsletter for devotees of value investing.
"It's not what I would describe as the easiest effort," he said of value investing.
Davis' job is to search below the surface of a company. "In general, I'm looking at a company's ability to produce cash and produce clean profits."
Davis begins by searching the undergrowth, beating the bushes, running down dark holes, looking for anything that might signal "market neglect."
Sometimes a company has earnings and income growth for two to three years and has a strong market for its goods and services, but Wall Street ignores the signs. This is market neglect.
Davis also looks for "fallen angels," stocks which have slumped as a result of bad news which may not accurately represent the company's fundamental condition.
If a company has had consistent growth over a couple of years, but experiences a bad quarter or two -- and management recognizes and is dealing with the problems, it may be a fallen angel.
These adventurers do not operate on gut instinct alone. All value investors follow the trails of Benjamin Graham, a man of science who did some of the earliest exploration of assessing stocks.
In 1923, Benjamin Graham began managing stock portfolios in New York. He gradually developed the formula which future value investors have tried to decipher in order to lead them to undervalued stocks:
Value =
Current (normal) earnings X
8.5 +
2(expected annual growth rate)
Like an economic Indiana Jones, Graham taught an investing class at Columbia University in New York City. There, he taught many students his theories on valuing stocks. One of those pupils, Warren Buffett, went on to become a renowned value stock explorer in his own right.
The exploration for undervalued stocks is fraught with pitfalls, any one of which can swallow up an investment whole.
Even those who go out every day hoping to find an undiscovered stock admit there's no easy way of discerning if your stock find is the Holy Grail or merely old junk.
Ed Vogrins, director of research for Investment Partners of America, said value investors can put too high of an emphasis on the price to earnings ratio, which is the price of a stock divided by its earnings per share.
"If one company is trading at 35 times earnings and another company [in the same industry] is trading at 27 times earnings, that doesn't mean the latter is cheap," said Vogrins.
Additionally, value investors may be led down a false trail when they stumble upon a struggling company that emerges with strong quarterly earnings, only to discover the rebound is the result of a one-time sale of assets or some other non-recurring activity.
"Most of the companies that you see today that are undervalued deserve to be undervalued because they're poor companies," said Vogrins.
That doesn't mean undervalued stocks exist only in legend, like an investment El Dorado.
Despite the market's constant search for stocks, many companies' shares continue to lie hidden because Wall Street simply can't afford to send out enough people to look for them.
Of the approximately 10,000 stocks on the major exchanges, only about 3,000 are covered by Wall Street analysts. (Hiring analysts can often be expensive.)
Brokerage firms also need to have a fairly liquid market in which to buy and sell. Value stocks, almost by definition, often need to be held for a longer period of time.
And, since many of the stocks Wall Street doesn't follow have small capitalizations, a brokerage might have to buy a larger percentage to make the investment worth their while. Most firms are loathe to have such a large holding in one company.
For these reasons alone, smaller investors have an opportunity to head off for unexplored territory. If even 10 percent of the 7,000 stocks ignored by Wall Street are undervalued, that presents 700 opportunities for making money.
One of the most important tools you will need to start off on your quest is easily obtained. Each year, companies put a 10-K report, which details almost every aspect of their operations over the course of the previous year.
Companies must file these forms with the U.S. Securities and Exchange Commission. The SEC provides a searchable database which anyone can use.
Examine, also, the form 13-D to look for evidence of what's known as "insider buying." This occurs when people within the company begin buying stock in their own firm.
While people can have many reasons for selling their company's shares, insider buying can be a more reliable indicator of confidence in the company. Several Web sites, including Insider Trader, track the insider buying and selling of company shares.
The sweat, toil and pain of hunting for value stocks can eventually pay off.
Alan Snyder, president of Snyder Capital Management, is one of those value investors who emerged from the wilderness with buried treasure.
His find? Greyhound Lines. Inc. (BUS). Greyhound is the largest bus company in the United States and the only one with a regular intercity schedule.
However, silk-suited brokers ignored the company's value, said Snyder. "The people who invest on Wall Street are not customers of Greyhound. They haven't looked at the company or tried the product."
The perception on the Street was the company was on hard times and its stock suffered accordingly.
"Meanwhile, they had been posting substantial increases in almost every area. The stock was on its butt," explained Snyder.
Heedless of his own personal safety, Snyder dashed after the stock. In February, the company posted its first profit in four years and the stock has almost doubled in price since the beginning of the year.
-- by staff writer Randall J. Schultz
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