The principles of buying stocks are a fairly simple concept: buy low and sell high. Knowing what low and high is when analyzing stocks can be a trickier matter. The following are five steps I use to find stocks selling for below their value:
1. Go to the following website (or a similar one) to find stocks that suddenly plunged in price:
I generally log on to this site every morning around 9:45 AM to see which stocks lost the most money at the start of the day:
If you scroll down to the losses section, you will see the stocks for the day that have the highest losses. Call me crazy, but I only buy stocks that plunged 5% – 10% over the course of the first 20 minutes of the day. To quote billionaire investor Warren Buffet: “The best thing that happens to us is when a great company gets into temporary trouble…We want to buy them when they’re on the operating table.”
The best time to purchase a stock (i.e. buy low) is when the price suddenly plunges, provided you investigate it properly with the next three steps.
2. Examine the stocks performance over the last year: I usually only but the stock if it’s trading near its lowest point for the year, or at the very least its lowest point for the last month. If despite the stocks drop, it’s still selling for way more than it was last year, this isn’t always a bad sign. This is especially true if the economy was weaker last year.
3. Look up the value score of your stock: Any online brokerage firm worth its commission fees will offer you free investor analysis tools for all stocks you own or are thinking of purchasing. Within the reports there is usually a value score. Simply put, the value score tells you how fair the price on the stock is.
Remember Beanie Babies, the overpriced stuffed animals of the late 90s? They were fairly expensive, however today some are worth quite a bit of money.
The manufacturer knew in advance the items would become collectible (as they strategically “retired” certain animals to create future scarcity) and priced their items accordingly. This is why people were willing to pay a premium for the animals on release; they anticipated they would be worth more in the future due to limited production today.
Stocks function similarly. A stocks value is greatly influenced based on supply and demand; the more people buying it the higher the price goes. If there are only three red cars in town, and 20 people want a red car, the car dealer will sell those three to the highest bidder. With 20 bidders, the price will likely go quite high.
Conversely, if there were 20 red cars in a town and only three people wanted them, the sellers would be competing with each-other to get rid of the cars before all three buyers found one. As a result the price would be very low.
Like the Beanie Babies, a stocks price often reflects its future anticipated value. 3D printing stocks are a great example. One company in particular had a greatly overvalued price due to all the hype about how 3D printers would revolutionize the world. Thus, the fantasy of the 3D printing stock exploding like the next Google or Microsoft was already included to a great degree in the stocks price.
Since noone can predict the future (and analysts are often wrong), how fair and accurate a price is in respect to future earnings can vary greatly. This is where value scores come in.
As a general rule, I only buy stocks that are fairly valued or undervalued. Very rarely will I buy a stock that is overvalued.
4. Find out why the stock plunged: There are several reasons why a stocks value can suddenly plunge:
Anticipated or actual missing of earnings
This typically happens when at the beginning of the year. A company estimates how much money it thinks it will make, and as a result, investors get excited and buy a lot of the stock and the price rises.
As the year rolls on, with sales dipping and reality setting in, the company may backtrack and say it now isn’t so sure how much money it is going to make this year. This of course panics investors who begin to sell the stock, lowering its price. This creates an opportunity to buy the stock at a discount, especially if the earnings end up being not as bad as the company anticipated. Even if the company actually misses its earnings, this is not necessarily an indication it won’t meet them in the future.
Decline/obsoletion of industry
This one is pretty self explanatory. Buying stock in a video rental store or cash counting machine manufacturer may not be a wise choice due to the declining relevancy and use of their product. This is a careful factor to consider when a stock declines, as fleeting viability of a business model is one of the hardest things for a company to recover from. Unless the company has a solid plan to adapt to ever changing technology, steer clear of companies facingt these challenges
This is probably my favorite reason for a stock losing value since it is based entirely on emotion rather than logic. Quite often a company will receive bad press for something they were responsible for (whether intentionally or inadvertently). Usually the public will react and sales will drop. Investors will fear a decline in value due to decreased sales and panic sell. Even better is when the media simply predicts sales will drop by hyping up the scandal with bad press (causing investors to panic sell), when in reality no one really cares, and sales are not impacted.
Emotional hype like this can cause perfectly healthy company to lose value overnight due to a scandal that has nothing to do with its profitability. While this may result in short term losses, consumers don’t typically hold grudges very long and the price will usually soon bounce back.
As a general rule, if a stocks price goes down solely because consumers are angry with a company I usually can’t hit the buy button fast enough.
Unlike missed earnings, if a companies balance sheet simply isn’t adding up, stocks will often plunge based on its finances. I often evaluate stocks I buy like a bank evaluates potential borrowers. If they have a horrible debt to income ratio or are hemorrhaging massive amounts of cash every month, I will usually steer clear of investing with them. You can potentially earn a large profit if the company ends up turning around, however I am a more conservative investor and that’s more risk than I’m willing to accept.
5. Timing is everything
The market is especially volatile in the morning. Volatility creates the greatest chances to make (or lose) money. The obvious goal of buying a recently plummeted stock is to buy when the price is at its lowest point. I have noticed that stocks that drop sharply at the beginning of the day will typically regain about 10% – 20% of the amount they lost by the end of the day. I can’t pin any science on this, but I usually notice the most common “low” point of the day is between 10:15 – 10:40 AM. I don’t know if there is any reason to this, but that is when I have had the most luck buying a stock at its lowest point.
I hope these tips will prove helpful to you. If you would like to see the returns I have made so far using this method check out this article.
(By Finance editor)
Disclaimer: These methods work for me, but they may not for you. You could potentially lose money in the stock market, but I assume you knew that already.
Image courtesy ddpavumba / Freedigitalphotos.net