How to find undervalued stocks? One way is to use market pessimism to unveil some value-stock gems

John Templeton, one of history’s most successful investors, played a big role in my investment education—and helped me learn how to find undervalued stocks

One of Templeton’s most valuable investing guidelines is, “Invest at the point of maximum pessimism”. It’s also among the easiest Templeton quotes to misunderstand, and one that’s often misapplied.

Note that Templeton didn’t say, “Invest only at the point of maximum pessimism”. Yet many investors take this quote to mean that you should hold your funds in T-bills or a bank account until you see “blood running in the streets” (a quote from another famed investor). That would be problematic to say the least. Pessimism is an open-ended condition. Pessimism never gets so bad that it can’t get worse.

How to find undervalued stocks using your brain, not your emotions:

Even so, market pessimism can let you find some undervalued gems—stocks that drop along with market as a whole but still have sound fundamentals. But one of the sweetest and most profitable pleasures of successful investing is to buy high-quality “value stocks” (or stocks that are reasonably priced, if not cheap, in relation to its sales, earnings or assets), then hold on to them as investors recognize the value and push up the share price.

Value stocks are typically stocks trading lower than their financial fundamentals suggest. They are perceived as undervalued, and have the potential to rise. Many new tech stocks, for instance, start out as growth stocks and transition into value stocks.

When they look for value stocks to buy, investors usually start by looking at a few basic ratios.  For example:

1. Low price-to-earnings and price-to-book ratios—signs of cheap or undervalued investments.
2. Low price-to-book-value ratio—another sign that stock is cheap in relation to other stocks on the market.
3. High dividend yield—the stock’s annual dividend divided by the share price. A high dividend yield could indicate a cheap stock that is set to rise.

Growth stocks can be good additions to your portfolio—but you should also include value stocks. That’s because a growth stock can be a top performer while the company is growing. However, a single quarter of bad earnings can send it into a deep, though often temporary, slide. Value stocks can test your patience by moving sluggishly for months, if not years. But they can make up for it by rising sharply when investors discover their true value.

How to find undervalued stocks by ignoring pessimism and searching for the light

Maximum pessimism is easiest to spot in retrospect, since you can then measure it against subsequent events. One good example occurred in February 2009. A prominent Toronto investment figure, known for strong long-time views on stocks (bearish) and gold (bullish), convened a meeting in a downtown Toronto theatre. Some of the most prominent economic pessimists on the continent came to deliver bad news on the outlook.

The event was a great success, but the timing was unfortunate; it came around a month before March 9, 2009. That’s when the 2007-2009 stock market hit its final low.

If you’ve followed investments for a number of years, you’ve lived through similar moments of maximum pessimism. I recall a time in the fall of 1990, when the UN was debating the coming U.S.-led invasion of Iraq, following Iraq’s invasion and takeover of Kuwait. One of the main Toronto daily newspapers was taking a near-hysterical reaction to the possibility of an Iraq war. Its pessimism spilled over into its coverage of unrelated news. One day it ran three front-page stories, each of which had the word “crisis” in the headline.

I don’t know if most investors saw that as an indicator of maximum pessimism. But it stands out as a good day to have bought value stocks. The Dow Jones Industrials rose more than four-fold in the decade that followed.

The air is full of pessimism today. More is possible, of course, but that would take “new” bad news. “Old” bad news fuels today’s pessimism. For instance, the media harp endlessly on the Federal Reserve’s plans for raising interest rates. When the inevitable increase comes, it won’t surprise anybody.

My view is that we are near a point of maximum pessimism. Pessimism may deepen, and stock prices may drop further, but now is a better time to buy value stocks than to sell them.

How do you make decisions about how to invest? Share your experiences with us in the comments.