The stock market has taken investors on a wild ride this year.
After the first quarter’s sell-off and the subsequent market rebound in the second quarter, stocks remain volatile — and that has opened up opportunities for investors to buy shares at a good value.
Whether you’re looking for a short-term investment or want to make strategic buys for long-term holdings, you’ll need to know whether a stock is undervalued, overpriced or a value trap. Here are three tips to keep in mind when you’re trying to find an undervalued stock:
— Know your intent.
— Consider price-to-earnings ratios.
— Look at dividends.
Know Your Intent
John Person, founder of Persons Planet, a trading education and advisory service company, says whether a stock is considered undervalued or a value trap depends on your intention and time frame when buying the stock.
He points out two companies — drugstore chain Walgreens Boots Alliance (ticker: WBA) and telecommunications firm AT&T ( T) — that are close to their 52-week stock price lows, as well as energy firm Exxon ( XOM), which is not only close to its 52-week low but also making multiyear lows. “All of their price charts look the same,” he says. “They’re not really going anywhere.”
If you’re looking for short-term, momentum-type trades, these could be considered value traps because they don’t show much volatility and investors are unlikely to see any quick price appreciation.
However, as Person points out, all three have dividend payments that are well above the S&P 500’s average dividend yield of about 2%. Walgreens has a 4.5% dividend yield, AT&T’s is 6.9% and Exxon’s yield is 8%. If you’re focused on long-term income, then these could be good values.
There is some debate about Exxon, given the drop in crude oil prices earlier this year due to swelling oil supplies and a falling demand because of the economic slowdown caused by the pandemic. Some market watchers say oil companies are unlikely to keep up with their robust dividend payments, but Person differs. As long as crude oil prices stay above $35 a barrel, he believes Exxon’s dividend payment is sustainable.
Person says most new investors only think about low-priced stocks that go nowhere as value traps, but investors can also be sucked into value traps when stocks are rising. For example, he points to the strength of online retailer Wayfair ( W). In early March, Wayfair traded around $23.50. Now it trades for more than $215 — a roughly 900% increase.
“It pays no dividend; the company doesn’t make any money, but the stock took off because everyone’s ordering online,” Person says. “To me, that’s a value trap because it’s trapping people to (buy) a stock that people think is going to go up forever.”
Consider P/E Ratios
When Person evaluates potentially undervalued stocks, he looks for shares that are breaking out of their trading range.
He compares a stock’s relative performance to the S&P 500. If the stock is outperforming the broader market, he then reviews the company — looking at its business model and what it does. He reviews its price-earnings metrics and compares that information to its peers and the broader market.
In general, Person prefers companies with low P/E ratios and stays away from companies with high P/E ratios.
“Will they ever turn a profit if they’re so far out of their earnings? You see companies with 20 times, 30 times, 60 times, 80 times earnings. To me, those are value traps,” he says.
David Yepez, equity analyst and portfolio manager at Exencial Wealth Advisors, says low P/E levels can be a sign of an undervalued stock, but it’s important to ask why the P/E level is low compared to industry peers. “Ask yourself: Why is this low? What are the trends? What are new companies coming with new technology,” he says.
Considering how much technology has impacted companies across sectors, when it comes to finding undervalued companies, investors also need to look at a company’s management team to see if they have a track record of adjusting or adapting to disruption.
“Sometimes it can be as simple as acquiring their competitor. Look to see if management is bringing in the right team, the right people so they aren’t be disrupted,” he says.
Yepez adds that growth stocks can also be good values, though finding them can take some evaluation skill. Investors who are looking for price appreciation need to keep an eye on the stock and go slowly. He says the move to more people working from home and learning online because of the pandemic could have ramifications.
One stock his company bought a small position in a few months ago is 2U ( TWOU), which helps universities with online learning. “I think we’re at the beginning stages of this, and we’re keeping track of it,” he says.
Look at Dividends
Michael Skillman, CEO of Cadence Capital Management, says his firm uses dividends to discover undervalued stocks. He finds dividends more useful than other traditional fundamental measures such as price-to-book ratio, discounted cash flow, P/E ratio and intrinsic value.
Specifically, he looks at price-to-dividends ratios when trying to determine a company’s valuation. “Dividends are a company’s ability, after funding their growth, to return capital to shareholders,” Skillman says.
He says companies are loathe to cut dividends because shareholders depend on that steady increase in income. If a company has a distribution greater than the S&P 500’s average dividend, which he calls “premium income,” investors should dig into the company’s financials to make sure it can continue to pay that distribution consistently.
“Does that company have the financial strength to continue paying that current dividend, No. 1, and No. 2, to raise that that dividend so you get some dividend growth over time,” he says.
That’s critical because some companies will boost the dividend payment to attract investors, but the payment may not be sustainable. Skillman says during the first-quarter market sell-off, companies with artificially high dividends were some of the worst performers compared to companies that didn’t pay a dividend or had a lower dividend.
That’s unusual because most dividend payers do well in market downturns, but the pullback revealed these dividend payments were likely unsustainable.
Specifically, Skillman says the fall in some high-dividend-paying names was very evident in energy companies, for example, because investors were shying away from companies with cyclical exposure and high debt levels.
“You can see that was a logical step,” he adds.
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