How to find Mispriced Stocks

For those of you that believe the market is efficient in pricing stocks then I suggest you read no further. Those people, the efficient market believers, must truly think that humans are emotionless creatures that do not have ulterior motives. Stocks get mispriced by the market constantly and I will explain the many different reasons this can occur.

It is vital that once you spot an undervalued stock that you ask yourself why the stock got so undervalued. If you fail to come up with a reason then chances are your stock isn't undervalued and the market is properly pricing it.

The most common reason a stock sways from its intrinsic value is because of a general decline in the overall market. Unfortunately, this occurrence generally will not help an investor. When the overall market drop it naturally brings down most stocks with it. Therefore, the stocks that you are currently holding in your portfolio will probably face similar declines to the stock you are looking at. The only way to take advantage of an overall market decline is by having cash on the sidelines to deploy.

Human nature has played a big role in equity pricing over the last century and you can be certain that it will continue to play a role in the future. Just as you can be sure that when you show your dog a treat, he will sit. It is instinctual and built into our DNA. The most successful investors are experts in taking advantage of human instincts.

A company reports earnings four times a year and the market is very shortsighted when looking at those earnings. So if you see a stock that drops because of poor earnings dig a little deeper to find out the reason for the bad numbers. You want to see if the company can correct the problem or if the problem is more of a fundamental nature. If the numbers are bad because of fundamental business economics of the company then you want to stay away from that investment.

My favorite type of mispricing occurs because of the brokerage industry and the mentality of those in the industry. The mispricing occurs because of a downgrade of the stock. I find it comedic that at the top of bull markets the analysts have a majority of buy ratings out on the stocks and during the trough of bear markets the analysts have a majority of sell ratings on the stocks. In reality, the brokerage firms make your job of finding mispriced stocks even easier. They generally tend to downgrade stocks after their stock price has already been beaten up. Subsequent to the downgrade, the stock price drops even further, providing you with a greater margin of safety then before the downgrade. What a gift!

Institutional investors are another great place to look for reasons as to why a stock might be mispriced. Institutional investors are the big Mutual Funds and Pension Funds that run billions of dollars. These guys are invested in every sector and tend to use asset allocation and as a consequence pay very little attention to the fundamentals of the individual company they are invested in. So when you see a major institution selling a stock you are in, don't be so fearful. In fact, there is a good chance that they gave you a better and cheaper entry point into the stock. One reason an Institution might sell a stock is that they are allocating more funds to a different industry and need to sell stock to obtain capital. Another reason could be that the Institution is having redemptions. (investors in fund pulling out their money) The fund is forced to liquidate some of their positions in order to pay back their investors. This forced liquidation occurred in 2008 as fear drew so many people to pull money from their Mutual Funds.

There are countless other reasons why a stock might get mispriced. Just remember to do your research and try and figure out an estimate of what a particular company is worth. When the stock falls well below that value it is generally a great time to buy that stock. Just picture that you are at a car auction and see your favorite car the Ferrari Enzo. Let's say that if you went to a car dealership to buy the car you would pay 1 million dollars. But at this auction, for whatever reason, nobody is bidding on the car, and the opening bid is for 500,000 dollars. Of course, you are going to put in a bid and buy the car. Did the value of the car change because there were no bidders? Of course not. Same thing with investing.