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Undervalued and Relatively Undervalued Stocks

Any stock can be undervalued. It can be a company that’s underperforming and has been given a low valuation.

Questions and Answers from the Conference

Investing in Undervalued, High-Quality Companies

Beating Warren Buffett

The second annual Cabot Investors Conference is now over but for investors who traveled to Salem, Massachusetts, the journey was well worth the time and expense.

Cabot analysts shared ideas on where the market is headed, which investments we like best right now and much more. In this Cabot Wealth Advisory, I’ll share with you a few of my words of wisdom from the conference.

Questions and Answers from the Conference

Where do we find our best ideas? (question asked of all analysts at a panel discussion)

My Answer: I use a “bottom-up” approach whereby I use a screening process on several databases. Each month, I start with data from Value Line, Standard & Poor’s, the American Association of Individual Investors (AAII), Investor’s Business Daily (IBD) and Zacks.

I screen my data down to 30 or more stocks by eliminating high-risk stocks, over-valued stocks and stocks with negative outlooks. I then scan analyst reports and company websites to find the companies with the best prospects. When I have the stocks that I think I want to recommend, I read additional reports on these stocks to make my final selections.

How do we invest in a changing world? (question asked of all analysts at a panel discussion)

My Answer: Don’t change your system. If you have a good system that has worked well in the past, it will work well in the future. Don’t alter your system when your performance stumbles. No system will work 100% of the time. Even the best analysts with the best systems go through periods when performance is subpar. Stay with your system; don’t abandon it.

If you don’t have a reliable investing system or methodology, I happen to know where you can find an ideal system to attain your goals and objectives. Cabot has assembled the best team of analysts in the investment world. That’s a very bold statement, but each of us are seasoned veterans who have developed very different investment approaches. The approaches we use have trounced the stock market indexes consistently for decades. I could go on and on, but suffice it to say that no matter what your investment needs are, we can help.

How do we sell better? (question asked of all analysts at a panel discussion)

My Answer: Use sell target prices. Before you buy a stock, determine the price you want to pay and the price at which you want to sell. Update your sell price objective, up or down, after quarterly results are reported and after major news is disseminated from your company.

And watch for management underperformance and sales and earnings misses. Before you sell, though, find out why the company is not meeting your expectations, and whether the poor results are short-term bumps-in-the-road or long-term problems. Sell your stock if it looks like the problems are going to prevail for more than six to 12 months, but hold onto your shares if your company is likely to bounce back within several months.

What is the difference between a value stock, an undervalued stock and a relatively undervalued stock? (from my opening remarks in my Value Stock Fundamental Analysis presentation at the Cabot Investors Conference)

My Answer: Any stock can be undervalued. It can be a company that’s underperforming and has been given a low valuation by investors, or it can be a rapidly growing company that is valued incorrectly by investors. The former is generally deemed to be a “value stock,” and the latter is usually considered to be an undervalued growth stock.

What is the difference between the Cabot Value Model and the Special Features Model? (from several attendees at the Cabot Investors Conference)

My Answer: Cabot Value Model is included in the Cabot Benjamin Graham Value Investor edition sent out usually on the first Thursday of each month. The Model contains a list of 16 value stocks which are rated conservative investments. My Risk Ratings for the stocks are Very Low or Low Risk, and the companies typically pay dividends.

The Special Features Model is included in the Cabot Benjamin Graham Value Investor edition sent out usually on the second Thursday of each month. The Model contains a list of 16 undervalued growth stocks which are rated moderate-risk investments. My Risk Ratings for these stocks are normally Low or Moderate Risk, and the companies’ growth expectations are commensurate with the higher risk profiles.

What are NCAV or Net-Net stocks? (from several attendees at the Cabot Investors Conference)

My Answer: Benjamin Graham created a formula 80 years ago to find what he called “bargain issues.” NCAV is short for Net Current Asset Value and is calculated by subtracting Total Debt from Current Assets and dividing the result by the number of shares outstanding. This is the NCAV, which is divided into the current price of the stock to determine the Price-to-NCAV Ratio. Comparing the current price to the Price-to-NCAV Ratio will reveal whether a stock is a bargain. Stocks selling at less than the Price-to-NCAV Ratio are considered bargains, and stocks selling below a ratio of 0.67 were considered by Ben Graham to be bargain issues with a margin of safety.

During the past several months, I expanded my 1,000 stock database to 7,000 stocks so that I could identify stocks that might qualify as bargain issues containing a margin of safety. The companies that qualified were either small Chinese companies with dubious accounting procedures or very small U.S. or foreign companies with extremely volatile sales and earnings results.

But on further inspection of the stocks in my database, I determined that high-quality companies with Price-to-NCAV Ratios less than 3.00 were also bargains. These companies can produce exceptional stock price performance within one to two years, my usual holding period for the stocks I select. Avnet (AVT) was my first NCAV choice, which I included in the August 2014 Special Features Model. AVT has a Price-to-NCAV Ratio of 2.32. You can read more about the Price-to-NCAV Ratio and Avnet in the August 2014 Special Feature Edition.

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Investing in Undervalued, High-Quality Companies: Three Examples

In yesterday’s Cabot Wealth Advisory, Timothy Lutts mentioned that he chose Middleby (MIDD) for Cabot Stock of the Month subscribers in his August issue. In my July Cabot Benjamin Graham Value Investor, Cabot Value Model, I recommended MIDD because the company was low risk, undervalued and had very good growth prospects after it made an astute acquisition. The company soon reported better than expected sales and earnings, which sent MIDD shares soaring 23% in less than two weeks!

The story doesn’t end with Middleby, though. Yesterday, Burger King (BKH) and Tim Hortons (THI) announced their intent to merge. Tim Hortons was recommended in my May Special Features Model. The news sent shares of THI surging 19% higher to a price that I consider overvalued. I quickly recommended selling THI because the increased price exceeded my sell target, and there was insufficient reason to adjust my sell price objective. As a result, my subscribers captured a nice 36% profit in three months.

If your buy and sell targets are reasonably accurate, you can invest in undervalued, high-quality companies including undervalued growth stocks, leading to some huge gains. Bally Technologies (BYI), which makes gaming machines for casinos, was clearly undervalued last month when Scientific Games (SGMS) and billionaire investor Ronald Perelman became interested. Scientific Game’s announcement on August 1 to buy Bally sent BYI shares up 29% in one day, providing my subscribers with hefty profits since I recommended BYI in February 2014.

The key to investing for me and my Cabot Benjamin Graham Value Investor subscribers is to find precise buy price and sell price targets. I crunch a ton of numbers every month to find undervalued, high-quality investment opportunities at the right price, and the results have been outstanding. During the past 18 years, my recommendations have gained a very respectable 1,111% compared to smaller gains of 554% for Warren Buffett’s Berkshire Hathaway (BRK-A) and 230% for the Standard & Poor’s 500 Index.

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Until next time, be kind and friendly to everyone you meet.

Sincerely,

J. Royden Ward
Chief Analyst, Cabot Benjamin Graham Value Investor

P.S. Don’t forget to follow me on Twitter. I’m “@J_Royden_Ward” and I send out at least one informative tweet every day!

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J. Royden Ward has spent his entire career seeking strong investment returns for his clients while keeping risk low. In 1969, he developed a computerized model of stock selection based on formulas created by investment legend—and Warren Buffett mentor—Benjamin Graham, and since 2003, he’s been spreading his wisdom far and wide as chief analyst of Cabot Benjamin Graham Value Investor.