If you are able to find undervalued Canadian stocks of companies with a history of sales and earnings, those value stocks can lead to a strong portfolio

The best investment plans or systems use a combination of value investing and growth investing. But above all, they involve choosing high-quality investments and diversifying your holdings.

One important part of this approach, undervalued Canadian stocks, can test your patience by moving sluggishly for months if not years. However, they can make up for it by suddenly shooting up when you least expect.

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How to pick the best undervalued Canadian stocks

When you look for stocks that are undervalued, it’s best to focus on shares of quality companies that have a consistent history of sales and earnings, as well as a strong hold on a growing clientele.

High-quality value stocks like these take some work to find, even when markets are down. But when you know what kind of stocks to look for, you can discover them. Here are three of the financial ratios we take a look at as a useful guide to spotting undervalued Canadian stocks:

• Price-sales ratios
• Price-to-earnings ratios
• Price-cash flow ratios

Some of the best components of undervalued Canadian stocks are hidden assets

Typically, when you find hidden assets, you are well on your way to finding good value stocks. Indeed, some of the value stocks that have done best for our subscribers are well-established stocks that unlocked the hidden value in their real estate holdings, their brand names, their research and development, or other assets that were not on their balance sheets at full value.

This is also why we pay special attention to holding-company discounts and spinoffs that reward investors by bringing hidden assets to the fore.

All in all, the deeper the value a stock offers, the greater the potential for profit.

Our search for value inevitably begins with our three-part Successful Investor philosophy.

You’re unlikely to find undervalued Canadian stocks if you’re relying momentum-based investing

With momentum-based investing, investors tend to ignore value investing principles. Instead, investors focus on buying stocks that are going up, particularly in response to earnings reports that beat forecasts. These kinds of criteria are easy to track electronically, so momentum favourites tend to get overpriced quickly. When a momentum favourite reports an unexpected earnings downturn or warning, however, its share price can drop 25% to 50% instantly.

Remember, not all ‘bargain stocks’ have good value

The best investment plans or systems use a variation of our value investing approach. That is, they revolve around choosing high-quality investments and diversifying your holdings. Our three-pronged value investing program takes that general description a little further. We advise you to invest mainly in well-established companies; focus on companies that are outside the broker/media limelight; and spread your money out across most, if not all, of the five main economic sectors (Manufacturing & Industry; Resources; Consumer; Finance; Utilities).

However, while value stocks are generally good bargains, not all bargain stocks are going to pay off for investors. The search for value stocks that will rise, or at least hold their value over time, begins with sound “fundamental” investing.

Look for stocks that are trading at prices that seem cheap in relation to their sales, earnings and assets. Above all, look for stocks that have what it takes to be successful in the long term, even if investors haven’t yet anticipated just how successful the company can be.

Bonus tip: It is important to know when to sell and when to hold on to your undervalued Canadian stocks

Here are some guidelines to consider before you sell:

Be quicker to sell low-quality stocks, and slower to sell shares of high-quality stocks.

Before you sell, ask yourself this: does the stock have a poor outlook? Or, do you want to sell because it just doesn’t fit your portfolio? If neither condition applies, and you just think it has gone up too far or too fast, then you should ask yourself if selling will improve your portfolio, or if you just want to tinker with it.

Avoid portfolio tinkering, especially when it comes to selling stocks that you feel have gone up too far and too fast. One key fact about big winners is that they tend to go up further and faster than most investors expect, and they keep doing it for years, if not decades. If you sell them when they’re just getting started, you may never experience the joy or profit of having a big winner in your portfolio.

Some investors have migrated from value investing to faster-growing investments. To what extent have you shifted to growth investing?

How have undervalued stocks performed in your portfolio?