Why undervalued stocks remain undervalued 6 comments

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Often we look at some stocks in the market and wonder why the market has not taken note of such single-digit PE, below NTA, stable cash flow stocks and revalued them accordingly? Surely they are going to move soon?

But often they don't do so in a significant way for a long time, to the chagrin of the investor who may have taken a line of this stock. There are often reasons for this.

Quite often there is a lack of broker coverage on the stock. And that is due to lack of institutional ownership. Who does the broker do the research reports for? Clearly they would focus on their big customers: the funds, in the same way that airlines pamper their first- and business-class passengers. If the funds don't own the stock, they are not likely to track it and the broker won't be inclined to help support or push up the share price through favourable analysis reports.

The stock may lack newsflow. Constant news act as a sort of advertisement for the stock, making people sit up and take notice. Look at how Pearl Energy has kept itself in the spotlight by releasing updates on its drilling work (even though a few are effectively reports of dry strikes!); its share price has been strong because the public develops a strong association of the company to the oil theme, which is now red-hot.

And this brings us to the third reason, which is that the stock's sector is not in play. The best example is the construction sector, which continues to be seen as a sunset industry (and probably justifiably so, unless they venture more adventurously overseas). Companies like Chip Eng Seng have strong cashflows, good dividends and strong orderbooks but still their shares remain in the doldrums.

All these can effectively be classed into one main reason: the stock needs a catalyst. As a stationary ball needs a push to provide the initial momentum, so the undervalued stock needs a catalyst to fuel its price move. That is why I often turn to the last few pages of a company's annual report to look at its share ownership, to check for new institutional holders or increased stakes taken by existing ones. This is especially important for the small caps. The first institutional shareholder is always the most important, because it raised the stock's profile, and often starts a virtuous cycle of broker reports being initiated and new funds being attracted in. I also watch the SGX daily announcements closely no matter how busy I am, for news relating to stocks I am waiting to pounce on. The catalyst could take the form of any form of news: a new strategic shareholder (Hyflux and Isthimar and Temasek), a series of new contracts (CSE Global in recent days) suggesting future earnings momentum, persistent insider buying (Meiban); all this could bring the stock past its previous resistance price level (using technician lingo), create high trading volume which brings more market attention and creates a self-reinforcing cycle that translates into price momentum.

The million-dollar question now, of course, is do we buy such an undervalued stock (or hold it if we already own it)? Certainly this decision must be a function of (1)how certain we are of our research; (2)how deep we believe undervaluation to be; (3)how high do we think it could potentially go if it comes to the market's attention (eg. brokers start to initiate coverage); and (4) our timeframe. Essentially, the first three factors relate to our assessment of the probability-reward question. Is it probable that the stock's sector will prosper in the future (if it does, one can be sure it will become a trading theme), or if not, does it promise enough potential upside to at least be a "low probability, high return" bet? The last factor of timeframe relates to how ready we are to leave the money in the stock with the expectation that it might not earn anything for an extended period of time. Clearly the answer to this last issue will be different for the trader and the investor.