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How to Find Mispriced Stocks

- By Geoff Gannon

On Tuesday, I talked about how there are two good approaches to finding the next stock you should research: 1) Make a list of obviously great businesses. 2) Make a list of stocks that are more likely to be mispriced than the average stock out there.

Today, we'll talk about how to create list No. 2. How can you come up with a list of stocks that are more likely to be mispriced?

You can use GuruFocus to invert your thinking. GuruFocus is all about finding the stocks that value investors like. But value investors are themselves a crowd. So, as a GuruFocus member, you can type in the ticker of the stock you're interested in. If it's a stock that is owned by a lot of gurus - it's less likely to be mispriced. The stock is well-known. If the stock isn't owned by a lot of gurus, it may be more likely to be mispriced. What we're talking about here isn't whether the stock is good or bad. It's whether people like Warren Buffett (Trades, Portfolio), Bill Ackman (Trades, Portfolio), David Einhorn (Trades, Portfolio), etc. own it.

Is it popular?

I think of myself as a value investor. But, perhaps this isn't true. Because the stocks I own are usually not held - in any great proportion - by other value investors. For example, I own BWXT Technologies (BWXT), Frost (CFR), and NACCO (NC). No guru tracked on this website has even 1% of their portfolio in BWXT. Neither does any guru have even 1% of their portfolio in Frost. And no guru at all owns NACCO. So, I have over 90% of my portfolio in stocks that no guru has even 1% of their portfolio in. This doesn't mean the stocks I picked are good. The gurus are gurus for a reason. Their stock picks may be a lot better than mine. But, we know that the stocks I've picked aren't popular.

Less popular stocks are more likely to be mispriced. This means they are a better choice for what to research next. I have to say again, as I did in yesterday's article, that being a good choice for what to research next is different from being a good choice for what to buy next. Don't buy unpopular stocks blindly. But, do try to dedicate as much of your research time as possible to stocks that other investors, including gurus, aren't looking at.

I wrote on my blog, that I thought Omnicom at $65 a share (it has since risen from there) was a good stock to buy at that price. However, it was never an unpopular stock, an unfollowed stock, etc. Today, there are five gurus that have between 1% and 2.5% of their total assets under management invested in Omnicom alone. Some of those same gurus also hold shares of Interpublic or WPP. Big global ad agency holding companies aren't unpopular stocks. I may have believed that Omnicom was mispriced around $65 a share. But, even when I thought it was a little mispriced - I never thought it was unpopular, unknown, etc. People with a lot of assets under management know about Omnicom. They have researched the stock in the past. If they don't own it today - it's not because they don't know about it. It's because they don't like it for some reason. Stocks like BWX Technologies, Frost, and NACCO are different. Most money managers are unlikely to have researched those stocks. Many fund managers don't invest in nuclear (BWXT) or coal (NACCO). Banking is different. If I believe that Frost is a better than average bank or would benefit more from a rise in interest rates than most banks would - as I do - then it's possible investors may know banks generally quite well but not know Frost specifically very well.

Still, it's better to look at entire industries that you think other investors aren't looking at. A big part of BWXT's business is building nuclear reactors for the Navy. Most investors have never considered any business involved in nuclear reactor construction in any way. You want to look at industries like that.

What about timing? Here, we can talk a little more about banks. Historically, I had not looked at banks as stocks I might buy. I started investing in the late 1990s and through 2009 I had never really considered banks. I've been investing now for about 20 years and for the first ten of those 20 years - I didn't think about banks.

What changed?

Interest rates got low and (more importantly) they stayed there. Ironically: this made banks potentially attractive as stocks. That sounds a bit perverse. Obviously, low interest rates hurt banks as businesses. But what happened is that the low interest rates in 2010, 2011, and 2012 started - by 2013, 2014, and 2015 - to seem like a "new normal" for stock investors. In terms of timing, this is the best situation for finding a potentially mispriced stock. When an industry first hits a down cycle, there are a lot of investors thinking the industry will rebound. If oil drops from $90 to $40 a barrel, people think it might soon bounce back. But, if oil stays at $40 a barrel for years and years - hope eventually peters out. It's usually after investors have gotten bored of waiting that a slew of mispricings can occur.

I analyzed about half a dozen regional banks in the U.S. for my newsletter. I did all these reports around the time the Fed Funds Rate was at 0% to 0.25% and had been there for some time. Perhaps even more importantly, a lot of those reports were written up when the investing public was not anticipating rate increases to be probable within the next 12 months. So, investors were anywhere from 100% to 50% sure that because the Fed Funds Rate wasn't just low today, it'd stay low for the next year too.

This part is important. Mispricings tend to happen when investors have gotten used to seeing "no action" in a certain group of stocks, an industry cycle, etc. and yet also expect "no action" for at least another year. Both the view out of the rear view mirror and the view out of the windshield show the same boring "dead money" vista.

The Fed Funds Rate has since risen. And, perhaps more importantly, some analysts expect about three rate increases in the next 12 months. That's very different from a Fed Funds Rate below 0.25% and no rate increases on the immediate horizon. I still own one bank stock (Frost). So, I'm not saying it's time to get out of bank stocks. But, I am saying that the time to research bank stocks was when no one was sure when there would be any rate increases. In 1979, Warren Buffett (Trades, Portfolio) said you pay a very high price for a "cheery consensus" in the stock market. You also pay a very high price for a near-term catalyst.

Which brings me to Japanese net-nets. This is another example - like U.S. bank stocks about 3 years ago - of a "dead money" group. About 6 years ago, I decided to put a little over 40% of my portfolio in six Japanese net-nets. Most people who wrote to me about Japanese net-nets talked about catalysts. They said: "Sure the stocks are cheap, but they've long been cheap and they will long stay cheap." Japanese companies never get taken private, taken over, etc. There's no catalyst.

Within about 12 months, two of my six Japanese net-nets (one-third of them) were taken over. The take-over prices weren't high at all. If these same stocks had been taken over in the U.S., you would've gotten a better premium. But, the premiums were still very big relative to the price I paid, because the price I paid was so low. It also happened fast. The absence of catalysts is what made these stocks cheap.

Often, if you want to own really cheap stocks - you have to settle for owning stocks without a catalyst. Investors don't like not having "an exit strategy." Really, an investor - rather than a trader - should be a person who doesn't need an exit strategy. And a value investor should accept a really low price in place of a catalyst. But that's not how humans tend to work.

Stocks where you know the future isn't going to be any brighter for the next 12 months are often likely candidates for a mispricing.

Here, I want to talk about the difference between thinking something will happen in the next 12 months and knowing something will happen in the next 12 years. A good example of this is Hunter Douglas. Hunter Douglas is the world leader in blinds and shades. It's as much a U.S. company as a European company but it trades in Amsterdam. About three years ago, Hunter Douglas was pretty cheap. It was cheap for cyclical reasons. The business had - in the wake of the housing bubble bursting - put together a string of probably the five worst years it ever would in terms of things like margins and returns on equity. When a business like this doesn't look like it's going to "turn a corner" in the next 12 months, it can often be pretty cheap. But, as the leader in blinds and shades, you knew it would turn a corner eventually. In fact, Hunter improved its competitive position during the housing bust as some smaller competitors were willing to sell out and consolidate the industry even more. The time to buy Hunter Douglas was neither during the housing boom nor in the recent past . The stock got more popular as time put more distance between the housing bust and the current state of the economy. The time to study up on a leader in an industry is when that industry is both 1) At a cyclical low point and 2) Not yet forecast to turn the corner within the next 12 months or so. In other words, look for mispricings by having a longer time horizon than other investors.

So, let's get down to practical tips. Where can you go to get a constant supply of possible mispricings? One: you can read special situations blogs like Clark Street Value. Every stock written up on that blog is worth your time to research. They're not all good stocks. But, they're all situations that are a little complicated, messy, unpopular, odd, etc. Two, you can follow all the upcoming spin-offs by bookmarking a page like this one from Asif Suria's Insider Arbitrage website. Not all spin-offs are good stocks to buy. In fact, I'd say the average spin-off today is less interesting than when I started investing about 20 years ago. But, that's the "average" spin-off. There's always at least a couple interesting spin-offs per year. Two of the stocks I own today were bought either right before or right after a spin-off. The only stock I bought last year was the "remain co" part of a spin-off. I'll repeat my warning to research spin-offs blindly - but don't buy them blindly. I own the BWX Technologies part of the Babcock break-up and the coal part of the NACCO/Hamilton Beach break-up. In both cases, buying either the other part of the break-up alone or buying both parts would have performed much, much worse. So far, I happened to own the part that went up and not the part that went down. That's how I think you should look at spin-offs. Never think of spin-offs as these special situations that statistically tend to go up. Don't buy into them like you would buy into the magic formula or some other mechanical approach. Instead, think of a list of spin-offs as a list of stocks to research. A spin-off list is a better research tool than any screen you'd run.

Finally, you can look at "busted" stocks and hated stocks of some sort. Funko (FNKO) isn't a business I'd be eager to buy (they make the cute little pop culture figures with big heads that sell for about ten bucks at places like Hot Topic and Gamestop) but it is the kind of stock I'd be interested in. What I mean by that is simply that Funko is a busted IPO. The IPO went badly. So, there is a chance the stock got a lot of attention from investors and immediately left them with a negative impression.

No impression is better than a negative impression when it comes to finding stocks to research next. I'd always rather find a stock no one is talking about at all than a stock people are badmouthing. But a stock investors dislike is a better research candidate than a stock investors like. So, you may want to put together a list of stocks that plunged to earth like Funko.

Right now, there's a bitcoin bubble. I can't imagine investing in any stock that has done anything with bitcoin. But, odds are that at some point in the future stocks that were in some way involved with bitcoin will fall so far and eventually switch business lines to something else - that even a value investor like me will take a look at them. Some of these stocks will leave such a terrible taste in the mouths of their owners that it'll seem like no one will touch them at any price.

That is exactly what happened in the early 2000s. The net-nets you could find in the 2000s were often stocks that had actually been popular in the 1990s and then collapsed when that bubble burst. Eventually, their actual businesses started turning a small profit - but everyone who owned the stock was deep underwater (having bought during the dot com craze). These were the perfect conditions to create net-nets.

So, the flaming wreckage of past bubbles is a good place to look for stocks. But, it usually takes some time for prices to get low enough. I can't imagine there will be a lot of busted bitcoin related stocks worth buying within the next couple years.

But, it's stocks like that you want to look out for. As an investor, you are most likely to find a mispriced stock when other buyers and sellers of the stock are buying and selling for "trading" reasons rather than "investing" reasons.

If people are selling because a stock went up in price and they want to take a profit - that's a chance for you. If people are selling because they don't see what will cause the stock to go up anytime soon - that's a chance for you.

In fact, I'd say that's always the best sign of a potentially mispriced stock. If everyone says: sure, it's a fine business, good, safe, etc. But, I just don't see what will cause it to go up in the next year or two, that's the perfect time for you to research the stock.

(Disclosure: Geoff owns NC, CFR, and BWXT.)

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This article first appeared on GuruFocus.