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Three Simple Strategies Every Investor Can Use to Identify Deeply Undervalued Stocks

Famed value investor Benjamin Graham once quipped: "When you can buy a dollar for forty cents, you don't have to worry about what the stock market is doing." That simple credo succinctly sums up the theory of modern value investing -- only purchase stocks that are trading at a sizeable discount to their intrinsic value.

Graham's mantra follows the age-old Wall Street wisdom to "buy low and sell high" -- it sounds simple enough, but it is deceptively complex in practice.

Finding stocks that are trading for less than they're worth is a daunting task indeed. Furthermore, by its very nature value investing requires leaning against the consensus view and looking for pockets of value in less glamorous sectors and not-so-obvious stocks. These skills hardly come naturally to most investors.

Fortunately, however, there are a few time-tested strategies that can aid you in uncovering truly undervalued gems. Countless investing legends have used these basic, time-tested methods to produce market-thumping returns for decades.

Value Investing Leads to Spectacular Returns
The incredible rewards for spotting hidden value have been indisputable over the years. 

For example, Ben Graham, considered by many to be the "father of value investing," produced annualized returns of better than +17% between 1934 and 1956 -- delivering a whopping 27-fold gain for his investors. Graham's former student Warren Buffett has managed to produce sensational annualized gains of more than +22% over the course of the last 40 years -- more than double the return delivered by the S&P 500 during the same time period. 

More recently, renowned fund manager Bill Miller has notched impressive annual gains of 16% since the inception of his Legg Mason Value Trust in 1982, good enough to turn a modest $10,000 investment into $395,000 -- about $156,000 more than the S&P, net of expenses! 

All three of these luminaries (and dozens more not named) have their own unique investment styles and philosophies, but there is a common link to their success: all have made millions by focusing strictly on value stocks.

Of course, we can't all be the next Warren Buffett or Bill Miller -- nor do we have to be to stay ahead of the market. According to research firm Ibbotson Associates, value stocks delivered healthy annualized gains of +11% between 1968 and 2002, easily outperforming the +8.8% return of their growth counterparts. And while value investing has proven its mettle time and time again, it has done so with considerably less risk than other strategies. 

In other words, value investors have not only beaten the broader indexes over time, they have also been insulated from much of the market's volatility.

A handful of value investing secrets, gleaned from the playbooks of investing legends past and present, can help you identify superior long-term opportunities. With this in mind, today's report will shed some light on three proven value investing techniques. Better still, we have already put these simple, but effective strategies into practice -- and will be profiling some of our most promising finds. 

(1.)  Exploit Wall Street's Tendency to Overreact

Anyone who has followed the markets for any length of time is probably quite familiar with Wall Street's habit of wildly overreacting to disappointing news. For the most part, many analysts and investors simply can't see beyond the next quarter, so any setback at all can send shareholders scrambling for the exits -- even when the problems are temporary and entirely fixable. 

While these knee-jerk reactions can be hard to understand, they are very easy to spot -- and profit from. Simply ask yourself how much impact the concerns that have forced the stock lower will have on the firm's long-term potential. If the answer is little to none, then you might have found an attractive opportunity -- particularly if the shares were already underpriced to begin with.

Ceradyne (Nasdaq: CRDN) is a prime example:

Troops in Iraq and Afghanistan, especially those stationed in urban settings, are constantly vulnerable to enemy attack. The last line of defense for troops in this setting: body and vehicle armor. These days, the body armor used by the U.S. and several foreign militaries is made of advanced ceramic material -- ceramic is light, yet is also extraordinarily effective at stopping bullets.

Not surprisingly, the Pentagon has been ordering both body and vehicle armor in vast quantities in recent years. As a result, manufacturers have been struggling to keep pace with the explosion in demand. As one of the world's largest producers of ceramic armor, Ceradyne  has seen its earnings steadily increase under the weight of military demand. All those orders, in turn, led to a nearly +2,000% increase in the firm's stock price from the end of 2001 through the beginning of 2005. 

But in early 2005, Ceradyne reported earnings that slightly missed Wall Street's expectations. The result: investors panicked, fearing that Ceradyne's days of heady growth were history. Within three months, the stock had lost nearly half its value. 

Ceradyne's fall was a classic example of Wall Street overreacting to the slightest bit of bad news. While the company's earnings did fall short of the mark, there was a valid explanation for the shortfall, and the problem was short-term in nature. In this case, at the beginning of 2005 the U.S. military upgraded the specifications and capabilities of the body armor it issues to soldiers; Ceradyne had to change and refit its factories to handle the new requirements. That temporarily slowed production.

But as a technology leader in the armor market, Ceradyne was one of the only players with the capability to quickly meet the Army's new specifications. Within two quarters, Ceradyne was back on track and once again beating analysts' expectations. To this day, growth in the armor business has continued at a rapid clip.

As you can see in our chart, investors who recognized Wall Street's overreaction and bought the stock after the selloff were amply rewarded -- shares of CRDN recovered sharply, bouncing nearly +200% higher after bottoming out in early 2005. And Ceradyne is far from an isolated example. 

The standard reaction of most traders is to shoot first and ask questions later -- selling at the first whiff of bad news before fully evaluating the fundamentals.

When it comes to companies with solid long-term fundamentals and strong growth prospects, this tendency to overreact offers a golden opportunity for value investors. Well-researched investors can take advantage of this type of panic selling to scoop up high-quality stocks at bargain prices. 

(2.) Search for the Most Undervalued Stock in an Industry

Value is not always an absolute concept. Sometimes the most effective way to evaluate a company's true worth is to examine it in relation to other companies in the same industry group.

To organize this information, it's useful to create a table comparing a company to its industry group using several different valuation ratios. Often, one or a small handful of stocks will stand out as dramatically undervalued based on several different measures. These stocks are often prime value candidates.

Of course, just buying the cheapest stock in a group would be pure folly. Stocks often trade at a discount for a reason; fundamental problems or business risks unique to the firm could rightfully be holding the stock back. As always, it's necessary to carefully examine your value candidates for any fundamental weaknesses that could explain the valuation disparity.

(3.)  Use Discounted Cash Flow (DCF) Modeling to Find Stocks Trading Well Below Their Fair Value

When searching for value investments, investors commonly rely on the most tried-and-true financial measures: price/book, price/earnings, price/cash flow, etc. To be sure, such traditional valuation metrics can be useful, but they only tell part of the story.

For example, a low price/sales ratio means little when a company has razor-thin profit margins and is having trouble converting those sales to profits. Meanwhile, a single-digit trailing P/E ratio might look good on paper, but it can be misleading if the company's earnings are forecast to fall sharply in the years ahead.

Don't get us wrong -- when evaluating any stock, it's always important to examine these types of traditional valuation metrics.  However, even when properly applied, the aforementioned ratios are extremely subjective.  

This is why discounted cash flow (DCF) modeling is important to value investors. While valuation measures can be ambiguous and accounting numbers can be manipulated, cold hard cash never lies.  As a result, free cash flows are often a much better gauge of a firm's actual profitability.

Therefore, to determine an appropriate "fair value" for a particular stock, we simply project the amount of free cash flow the firm is likely to produce in the years ahead. From there, we determine how much those future cash flows are worth in today's dollars by discounting them back to the present at a rate sufficient to compensate investors for the risk taken. Finally, we then divide that figure by the total number of fully-diluted shares outstanding to arrive at our per-share fair value estimate.

By using our proprietary fair value calculations, we can quickly determine whether a particular stock is trading above or below its actual intrinsic value. If a stock trades at $30 per share, but has a fair value of $50, then we easily know that it is trading at a 40% discount.  While many veteran Wall Street pros use some version of this process, our unique "fair value" system and pricing methodology can't be found anywhere else -- it is only available from StreetAuthority.com. And by reading our newsletter each month, you can see our fair value estimates and know at a glance if a stock is trading at a discount -- it doesn't get any easier than that!

(4.) Stocks That Meet These Criteria

Now that we have shown you some of the best ways for value investors to find potential stocks, we had our research team find many that fit into each specific category. In the text that follows, we will bring you the names of some of the best values we could find . . .