Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 80

Cheap stocks: how to find them and how to buy them

People often refer to themselves as either ‘fundamental’ or ‘technical’ investors and feel so strongly about one style of investing compared to another that they engage in heated debates. We believe investors should use whatever tools are at their disposal to try to beat the market, and that fundamental analysis combined with technical analysis has a greater probability of achieving this than one style alone.

Understanding fundamental analysis

When we refer to fundamental analysis we mean the process of determining accounting profits, operating cash flows, free cash flows, balance sheet debt, cash and overall balance sheet strength, as well as estimating these metrics two years into the future.

There are about 2,250 stocks listed in Australia (2.5% of the world's listed market capitalisation) and in any given year 600 to 700 of these companies actually make a profit - so about 75% of Australia's listed companies do not. We are unable to analyse companies that do not make a profit.

Of the profitable companies, 5% are usually cheap and 5% are really expensive in any given year. This equates to a ‘sweet spot’ of about 70 companies that meet our fundamental criteria. We hope to construct a portfolio of between 30 and 40 core positions in any given year.

This approach is outlined in Diagram 1 below. Importantly, we need an open mandate to implement this investment strategy (that is, few restrictions on the fund's investment style). Investing with an open mandate is unusual in Australia and particularly in the superannuation investment industry, although this is changing. We estimate that around 85% of all super money invested is invested on a restricted mandate, effectively reducing the number of really good opportunities available to a portfolio manager.

Diagram 1. Identifying good and bad stocks from the listed universe

KS Chart1 190914

KS Chart1 190914

Diagram 1 shows that a typically cheap stock may have:

  • earnings growth of around 20% per annum
  • price-to-earnings (PE) multiple of around 10 times
  • 12 to 15 per cent operating cash flow (OCF) yield
  • 8 to 10 per cent free cash flow (FCF) yield
  • minimal debt on the balance sheet
  • (a 'long position' means the fund will buy that stock).

Conversely, an expensive stock may have or be:

  • growing at 10% per annum
  • trading on a PE multiple of 20 times
  • negative to 3% operating cash flow
  • negative to 3% free cash flow yield
  • lots of debt on the balance sheet
  • no cash
  • (a 'short position' means the fund will sell that stock).

The process of trying to identify cheap and expensive stocks is ongoing, and just as individual stocks exhibit cyclical earnings and valuations, so too does the overall share market.

At the time of writing, several sectors in the market are showing high valuations, and a smaller, more discrete, group of stocks are presenting as fundamentally cheap. This is often the case.

Using technical analysis

Diagram 2 shows how we buy and sell stocks. No matter how cheap we think a stock is, we are not allowed to buy if it is falling in price or in a downward trend. Conversely, no matter how expensive a stock, we do not sell or short-sell if it is in a price uptrend.

Diagram 2: Do not buy a falling stock, do not sell a rising stock

KS Chart2 190914Buying stocks that are falling and selling stocks that are going up are probably the two biggest mistakes that investors make. There are deeply engrained reasons for this and many psychological barriers within investors' psyche that often prevent them from buying stocks that are going up and selling stocks that are going down. In fact, investors are often compelled to do exactly the opposite.

An entry strategy to buy cheap stocks

Diagram 3, below, shows the process that we undertake once it has identified a stock to be cheap. We wait for the falling share price trend to finish (this is how a stock becomes cheap - people sell it). Once the price starts to recover we initiate a 1% (of our portfolio) position. At this point conditions are ideal to generate good risk-adjusted returns. We then add 1% and another 1% as the price rises, up to a maximum of 5% of our portfolio at cost into any one position.

Our core positions start as 1% positions initially so we do not have too much capital invested in any one new idea. Starting with a small position is another way of mitigating risk.

Diagram 3: Staged entry and exit points

KS Chart3 190914Diagram 3 also shows how we exit our positions once the long-term trend has ended and the stock becomes expensive. We sell a third of the position initially then another third and eventually the final third. In this way we are not making decisions about an entire position on a day-to-day basis.

The fundamental and technical processes in practice

Diagram 4, below, shows the combination of fundamental and technical analysis operating together using Macquarie Group as an example.

Diagram 4: Combining technical and fundamental analysis

KS Chart4 190914Shortly after reaching a peak of nearly $100 (on our fundamental analysis at the time, reasonably expensive), the GFC brought havoc and Macquarie's earnings fell substantially, along with its share price. It continued falling and at around $40 started to look reasonably cheap from a fundamental perspective. However, as outlined, we don’t buy a stock that is cheap but still falling in price.

Macquarie subsequently traded as low as around $17 and then recovered to its current price of around $57 ($61 if you include the recent spin-off of Sydney Airports). Once the fundamental and technical picture for Macquarie lined up (that is, the stock was fundamentally cheap and technically going up), our approach was to buy with an initial 1% position at $23, then add to it again around $26, $28, $35 and $41, accumulating a 5% position at cost over time.

We believe, in this example, had we started buying when we identified Macquarie as fundamentally cheap when the share price was still falling, we would have been taking unnecessary risk and incurring large losses before the stock price had finished falling and started to rise.

From a fundamental perspective, it does not matter how cheap or expensive investors may think a stock is, should the share price still be falling it is not a good time to buy technically, and should the share price still be rising, it is not a good time to sell technically.

Karl Siegling is Managing Director and a Portfolio Manager at Cadence Capital Limited (ASX: CDM). This article provides general information and does not constitute personal advice. 


 

Leave a Comment:

     

RELATED ARTICLES

Technical versus fundamental analysis in equity markets

What makes a company attractive?

Squiggly lines and lessons in market timing

banner

Most viewed in recent weeks

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

House prices surge but falls are common and coming

We tend to forget that house prices often fall. Direct lending controls are more effective than rate rises because macroprudential limits affect the volume of money for housing leaving business rates untouched.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

100 Aussies: five charts on who earns, pays and owns

Any policy decision needs to recognise who is affected by a change. It pays to check the data on who pays taxes, who owns assets and who earns the income to ensure an equitable and efficient outcome.

Three good comments from the pension asset test article

With articles on the pensions assets test read about 40,000 times, 3,500 survey responses and thousands of comments, there was a lot of great reader participation. A few comments added extra insights.

The sorry saga of housing affordability and ownership

It is hard to think of any area of widespread public concern where the same policies have been pursued for so long, in the face of such incontrovertible evidence that they have failed to achieve their objectives.

Latest Updates

Strategy

$1 billion and counting: how consultants maximise fees

Despite cutbacks in public service staff, we are spending over a billion dollars a year with five consulting firms. There is little public scrutiny on the value for money. How do consultants decide what to charge?

Investment strategies

Two strong themes and companies that will benefit

There are reason to believe inflation will stay under control, and although we may see a slowing in the global economy, two companies will benefit from the themes of 'Stable Compounders' and 'Structural Winners'.

Financial planning

Reducing the $5,300 upfront cost of financial advice

Many financial advisers have left the industry because it costs more to produce advice than is charged as an up-front fee. Advisers are valued by those who use them while the unadvised don’t see the need to pay.

Investment strategies

Slowing global trade not the threat investors fear

Investors ask whether global supply chains were stretched too far and too complex, and following COVID, is globalisation dead? New research suggests the impact on investment returns will not be as great as feared.

Strategy

Many people misunderstand what life expectancy means

Life expectancy numbers are often interpreted as the likely maximum age of a person but that is incorrect. Here are three reasons why the odds are in favor of people outliving life expectancy estimates.

Investment strategies

Wealth doesn’t equal wisdom for 'sophisticated' investors

'Sophisticated investors' can be offered securities without the usual disclosure requirements given to everyday investors, but far more people now qualify than was ever intended. Many are far from sophisticated.

Investment strategies

Is the golden era for active fund managers ending?

Most active fund managers are the beneficiaries of a confluence of favourable events. As future strong returns look challenging, passive is rising and new investors do their own thing, a golden age may be closing.

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.