Identifying and Investing in Undervalued Securities

Key Insight

Achieving superior investment returns over the long term necessitates a selection or operational policy that is both objectively sound and distinct from the prevalent strategies of most investors. A prime approach involves concentrating on large companies that are experiencing periods of relative unpopularity, predicated on the market's tendency to undervalue firms suffering from temporary setbacks. Larger companies are advantageous in this context due to their greater capital and intellectual resources, enabling them to navigate adversity, and because the market is typically quicker to react to any subsequent improvements they demonstrate. Studies analyzing the price behavior of 'low-multiplier' issues (the cheapest stocks) within the Dow Jones Industrial Average have consistently shown their outperformance. For instance, in 25 out of 34 one-year tests between 1937 and 1969, these cheap stocks clearly outperformed the average. An initial $10,000 investment in low-multiplier issues in 1936, systematically switched annually, would have grown to $66,900 by 1962, significantly exceeding the $25,300 for high-multiplier stocks or $44,000 for an investment across all thirty DJIA stocks.

A 'bargain issue' is defined as a security whose intrinsic value, based on analytical facts, appears to be at least 50% greater than its current selling price. These are identified through two main tests: appraisal, which estimates future earnings and applies an appropriate multiplier, and assessing the business's value to a private owner, often emphasizing the realizable value of assets, particularly net current assets. Bargains emerge from either currently disappointing financial results or prolonged market neglect and unpopularity. However, successful investment requires more than merely a decline in earnings and price; it demands indications of reasonable earnings stability (no deficits) over at least a decade, coupled with sufficient company size and financial strength to withstand potential future setbacks. A highly identifiable bargain type is a common stock trading for less than the company's net working capital alone, after all prior obligations, effectively acquiring fixed assets at no cost. A 1957 compilation identified approximately 150 such common stocks, with a sample of 85 yielding a 75% gain over two years (1957-1959), significantly outperforming the S&P 425 industrials' 50% gain, and notably, none of these issues showed significant losses.

Secondary companies, defined as those not leading major industries, are frequently undervalued due to a long-standing investor preference for industry leaders, a bias reinforced by experiences during the 1930s depression. This undervaluation presents opportunities, offering high dividend returns, substantial reinvested earnings relative to the price paid, generous treatment during bull markets, and eventual price adjustments to normal levels. Acquisitions of smaller companies by larger ones have become a significant factor, with acquirers often paying generous premiums well above previous bargain levels. Bargain opportunities can also extend to bonds and preferred stocks, particularly well-secured issues with low coupon rates trading at steep discounts, such as American Telephone and Telegraph 2 5/8s, due 1986, which sold as low as 51 in 1970, and Deere and Company 4 1/2s, due 1983, which sold as low as 62. While defaulted railroad bonds offered spectacular returns in the decade ending 1948, these situations are complex and best suited for investors with a deep understanding of values in this specialized area.