You have to turn over a lot of rocks to find those rare hidden gems. Sometimes the best approach is to simply start with the ‘A’s.

Searching For The Next Undervalued Opportunity

There are a number of different ways to go about searching for your next great investment idea. You can get hot tips from blog sites like this one, from financial newspapers and magazines or from investing podcasts. You can subscribe to investment newsletters, you can comb through 13F filings where top money managers report what they are buying and selling. You can keep CNBC running day and night in the background. There are an endless stream of financial pundits offering up both free and paid advice out there. Even though I am guilty of being one of those talking heads contributing to the deafening din on Wall Street, I personally don’t spend much time tuning into the noise. When it comes to finding my next overlooked, undervalued opportunity, my favourite approach is to roll up my sleeves and start with the A’s. I call this the “brute force” method of stock picking.

Nothing beats simply sitting down with a long list of stocks and going through them one by one, looking for that rare gem that has been overlooked by other investors. Not only can you stumble across great opportunities this way, you also get a very valuable perspective on the market as a whole. Researching individual stocks in isolation, it is easy to get lost in the details. Going through dozens or even hundreds of different stocks at one time gives you more of a bird’s eye view. By studying many different trees at once, you get a much clearer picture of what the forest looks like. Instead of hanging on every new pronouncement from the federal reserve chairman, try working your way through a long list of companies. You’ll get a lot more insight into what the economy is doing and where it’s headed that way than you will by tuning into the incessant media chatter.

To apply this brute force method, you need a list of stocks to start with. Online screening tools are a great way to generate your starting list. There are a variety of different sites that offer some basic stock screening functionality, many of them for free. There’s a good chance your brokerage offers its own screening tool. The actors in this space seem to be constantly changing and evolving so if you don’t have a favourite screening site already, your best bet is probably to just google “free stock screener” and see what you come up with.

It’s easy to get carried away with stock screeners. Some of them offer a bewilderingly comprehensive set of data points that you can use to sift and sort the stock universe. You could ask a stock screener to screen for stocks that are trading near their 52 week highs or their 52 week lows. You could look for companies selling at low price to book ratios or low price to earnings ratios or that have above average growth rates. You could identify stocks with high returns on equity. Or high dividend yields. Or insider buying. You could screen for excessive debt levels using a bevy of different indicators. The possibilities are quite literally endless. And it is very easy to get lost in the weeds with this stuff.

Your Stock Screener Can’t Pick Your Stocks For You

After playing around with these screeners many times over the years, I have come to realize that the best approach is often the simplest. Don’t try to use a screener to actually pick your stocks for you. They can’t do that. The data the screen is based on is often flawed or only tells part of the story. For example, the big sale of a division might boost the earnings at a company one year, resulting in a seemingly low p/e. But the next year when that sale has worked its way through the system, earnings will fall back down to earth and the company won’t look like such a bargain after all.

Likewise, a large one-time restructuring expense or a big currency exchange loss one year could depress earnings, producing a temporarily high p/e ratio that might exclude an otherwise interesting company from consideration if you were screening only for low p/e companies.

While it may seem like an attractive and time saving idea to set up a complicated screen that defines your ideal investment (high 5 year sales growth, low p/e ratio, low p/b ratio, low debt to equity ratio, high dividend yield, trading near a 52 week low, etc.), these sorts of screens are counterproductive. They are as likely to exclude that rare, deeply undervalued gem as they are to highlight it.

Far better is to set a couple of simple, broad parameters that generate a manageable list of companies to review and then go through that list one by one, evaluating each company on its own merits, reading the news releases, listening to the conference calls and downloading the annual reports. A screen can be a great tool for generating a useful list of stocks to look at, but from there, it is up to you to do the heavy lifting!

Spoiled For Choice

There are over 60,000 companies that trade globally. Clearly you need to narrow the playing field somehow to make that number manageable.

For many investors, it makes sense to start with stocks from your home country. If you’re lucky enough to live in Kazakhstan that means you only have 33 stocks you need to look at. Canadians have a few thousand to plow their way through. Americans have the most daunting challenge with over 30,000 companies to choose from.

Fortunately, many of these companies are easily weeded out with a few simple criteria. I often start by excluding certain industry sectors. Mining, energy, financials, real estate, biotechnology and utilities are sectors that I generally steer clear of. These companies don’t lend themselves well to my sort of earnings-based fundamental analysis. Instead, I focus most of my attention on industrials, consumer stocks and technology. This still casts the net fairly wide and exposes me to a lot of different companies doing a lot of different things.

Another great way to narrow the playing field is to focus in on a single market cap segment. Small, individual investors often start with the micro-cap sector, those stocks with a market capitalization of under $300 million. This is a great sandbox to play in as the larger, professional money managers of Wall Street are largely excluded from entry because of their size. Because you’re mostly dealing with other, individual investors like yourself in this space, the playing field is more level. Also, because they are small, the companies are less complicated and easier to understand. And they have the potential to someday grow to become small, mid or large cap stocks in their own right, enriching you mightily in the process.

Another great screening criteria is profitability. Is the company making money? At any given point in time, it is not uncommon to find that up to half of all stocks on the market are actually losing money. There can occasionally be good turnaround opportunities here but if you’re a new investor starting out, you can save yourself a lot of time and effort (and grief) by simply taking a pass on these unprofitable stragglers.

Using only these very basic screening criteria you can narrow a seemingly overwhelming list of prospects down to a few hundred prime candidates.

Armed with your shortened list and a sharpened pencil (or fresh excel spreadsheet), it’s now time to roll up your sleeves and get to work. Start with the ‘A’s. Move through the list company by company, evaluating each, without agenda or bias. I like to say I let the market tell me what to buy, not vice versa. Which is to say, I don’t start out with a preconceived notion of what I’m looking for like “something in the renewable energy space” or “a rapidly growing cannabis company”.

Instead, I evaluate each of the disparate companies on my list on its own merits, looking at earnings, past growth rates, debt levels and performance over all parts of the business cycle. I assign an approximate fair value to each based on these parameters and keep my eyes open for any stocks that have drifted far away from that fair value touchpoint. These I come back to and evaluate in even greater depth. It’s an intensive process and is not terribly elegant or refined. I’m simply out there in the fields, turning over rock after rock. But so far, I haven’t found any shortcuts that yield better results. The brute force method is still the best I’ve found to unearth those undervalued gems that we’re all looking for.