News Highlight 7

How to find undervalued companies
Key points
Once you find a sound business whose value is greater than its price, buy it with confidence
Price is what you pay, value is what you get
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Value buying requires you to do your homework.

How do you find undervalued companies? It's a challenge, the greatest one in share investing. Anyone who can consistently get this right will end up astonishingly wealthy. Just ask the "Oracle of Omaha", Warren Buffett, the world's richest investor who is worth around $US52 billion ($60 billion).

Buffett is the world's greatest exponent of so-called value investing. That is, seeking out and buying into companies with genuine business operations, sound fundamentals and good balance sheets — including low debt and high returns on equity — that are, for no particularly good reason, out of favour with the market and resultantly priced below their intrinsic value.

One of Buffett's great adherents in the Australian market is Roger Montgomery, managing director of listed funds manager Clime Asset Management. He bases his very long-term investment focus and company selection process on his mentor's model.

Montgomery says that once you find a sound business whose value is greater than its price, buy it with confidence, and buy lots of it. Furthermore, if the price falls further, he says you should buy even more.

Montgomery is not enamoured of widely-used valuation tools including CAPM (capital asset pricing model), beta (an indicator of short-term volatility and risk) or EMRP (equity market risk premium). He is particularly dismissive of pronouncements on a share's value based on its price-earnings ratio (PE).

This puts him at odds with many analysts and professional market commentators, who do place emphasis on a stock's PE ratio as an indicator of value. (The notion is, the higher the PE ratio, the more expensive the share, and therefore the greater the probability it is overvalued; the lower the PE ratio, presumably the more likely it is to be undervalued).

The main problem with PE ratios, says Montgomery, is that they only tell you about price. They don't tell you anything about value, because "value is independent of price. Price is what you pay, value is what you get. Valuing businesses and assets has nothing to do with observing where the price is, or where it has been, or where it is going."

An asset's price may be higher or lower than its value — the objective is to buy it, if it's worth buying at all, when its price falls below its separately determined value.

Montgomery determines a company's value using a number of inputs including return on equity (the higher the better), debt level (the lower the better) and dividend payout ratio.

Furthermore he needs to determine whether a target company has the ability to convert $1 of retained earnings into at least $1 of additional market value, and whether it has "competent management with integrity that acts more like an owner than a caretaker".

If all this comes up trumps, and the share price is below his conservative valuation, then it's a buy.

If you're thinking this all sounds pretty complex and intimidating, you'd be right. After all, if it was simple to pick value stocks everyone would be doing it and we'd all be rich.

Montgomery and Clime Asset Management do it using a software package, Clime's own, which incorporates the above inputs (plus more), called StockVal. This program, including ongoing price and performance updates, is available to the general public and costs $1595 for one year ($67 a month thereafter). See www.stockval.com.au for details.

For those investors reluctant to go down such a path, or for those of us who aren't all that proficient at reading company balance sheets, you can do what Greg Canavan, senior equity analyst at Fat Prophets, suggests when it comes to looking for value.

He recommends reading widely, noting the opinions of share analysts (not surprisingly) and favouring high-yielding, large-cap stocks with proven businesses and good management, while also taking note of their debt levels (the higher the debt, the riskier the company and the less appealing).

Russell McKimm, an executive director of Shaw Stockbroking, says to look for companies with sustainable earnings that are hopefully growing. He says profits drive share prices, but prices can get out of synch with fundamentals.

One way to find value is to look for sound companies that have taken market punishment due to a short-term glitch, but whose long-term prospects remain favourable. He points to Suncorp and IAG suffering a correction following the bad NSW June storms, but whose share price will bounce back as business returned to normal.