How to quickly spot undervalued stocks

Readers who have kept tabs with my posts on stocks and stock analysis tools may be aware that I focus on stock selection and don’t beat around the bush with fancy quotes.  In keeping with that spirit, here is a simple way to quickly spot undervalued stocks using Morningstar’s Quantitative Equity Ratings. This post is meant for new stock investors and not experts who like to find fault with everything.

I strongly believe investors who wish to try direct equity must do three things: A: Quicky start investing in solid companies. This will help: How new stock investors can quickly start investing using NIFTY Multi-Factor Indices.Learn how to value a stock in multiple ways. This free tool would help with that: Automated Earnings Power Stock Analysis With Screener.in data and this: 50 stocks with solid earnings power: Ability to self-fund and create value C Always keep track of the annualized returns of each stock and your entire portfolio. Preferably create a dummy mutual fund portfolio and invest the same amount (imaginary) that do in stocks in an index fund (nifty next 50) and an active mutual fund of your choice. If after 3-5Y, you cannot beat the index or the active fund, it is better to evaluate if you should spend time on direct equity investing (unless you want to do it for fun and education). This will help to find returns: How to calculate annualized return (XIRR) from a stock investment

Before we proceed, it is important to recognise that no valuation method is perfect and the following requires you to trust  Morningstar’s Quantitative Equity Ratings as the exact formulations are unknown. I have included as much information as I could find the necessary links. Also, not everyone will agree on what stock to buy or sell. So unless you have conviction and courage, you cannot get started.

How to find undervalued stocks?

1. Head over to Morningstar Equity tools. You will find this screen.

morningstar quantitative equity ratings 1 - How to quickly spot undervalued stocks

2: Click on undervalued stocks and it will open up this list

morningstar quantitative equity ratings 2 - How to quickly spot undervalued stocks

So now you have a list of 2065 undervalued stocks to choose from! Obviously, that is a bit too much and has to be reduced. This is where MorningStars other metrics come in. Before we proceed let us look at all four of them.

Quantitative Valuation

This is a ratio of the fair value estimated with discounted cash flows (DCF) and its current market price.  The rating is expressed as Overvalued, Fairly Valued, and Undervalued. It is not known how this rating is derived but the valuation method is well known: Automated Stock Analyzer with Discounted Cash Flow Valuation (this is a older version explaining the DCF). The main problem with any valuation method is the analyst inputs. These are crucial to the result and is based on a qualitative perception of risk and reward in a particular industry. So it will be arbitrary.

Quantitative Economic Moat

A moat is hole surrounding a castle to prevent attacks. Wider the moat, safer the castle. Warren Buffett used this term to identify the competition a particular company has in a sector. According to Morningstar,

We assign one of three Morningstar® Economic Moat™ Ratings: none, narrow, or wide. There are two major requirements for firms to earn either a narrow or wide rating: 1. The prospect of earning above-average returns on capital; and 2. Some competitive edge that prevents these returns from quickly eroding.

Quantitative Financial Health

This is a measure of how well a company will meet its financial obligations and is expressed as Weak, Moderate, and Strong.

Quantitative Uncertainty

This takes into account future possible outcomes of the companies share price. It is possible for it to fluctuate wildly due to its proposed activities and how they will be received? Or will it be stable as it is a well-established player?  The rating is expressed as Low, Medium, High, Very High, and Extreme. A low rating implies a more stable return (possibly low) and higher rating implies higher risk-reward and requires a greater margin of safety in valuation.

3: Now let us head back to our screener and demand the following:

Wide-Moat + Undervalued stock + low uncertainty + Strong Financial Health

Result: No stocks found. This is to be expected as we cannot demand too much! So now let us relax these constraints in different ways.

Wide-Moat + All valuations + low uncertainty + Strong Financial Health

Result: Three Stocks

morningstar quantitative equity ratings 3 - How to quickly spot undervalued stocks

Those are some solid companies to buy. Remember good companies will not become undervalued often. So if you don’t mind the price of entry and recognise that the reward will be decent from such companies if given enough time, you can consider these.

4: Wide-Moat + All valuations + medium uncertainty + Strong Financial Health

Result: Colgate, Dabur, HUL, Pidilite. Again, solid picks if you don’t mind the price.

5: Wide-Moat + All valuations + medium uncertainty + moderate Financial Health

Result: Avenue Supermarts Ltd I know nothing about this. So no comment.

6: Wide-Moat + Undervalued + high uncertainty + strong Financial Health

Result: Cummings India, Siemens. That does not look terrible does it?

7:  Narrow-Moat + Undervalued + medium uncertainty + strong Financial Health

Result: ACC, Ambuja, Wipro. Again decent?

You can keep playing with this all day to cough up multiple possibilities. The idea is to recognize the risks as you change the screening criteria. The point of this post is that you can quickly spot undervalued stocks, screen them further in terms of moat and financial health. The uncertainty gives you an estimate of future risk.

Depending on your confidence and comfort level, you can either buy or dig deeper. But always remember to visit the individual stocks MorningStar page (Avenue Supermart is linked above).  Please also do not fail to read the MorningStar reference documents linked below. Good luck. As always I would like to know what you think. If you have similar or better resources to quickly screen for stocks, let me know.

Reference Documents

Guide to Morningstar’s Equity Research Methodology

Morningstar Quantitative Equity Ratings Fact sheet

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