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Undervalued Stocks: Filter with Stock Screener

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Investors generally underperform the market because they do not buy stocks that are healthy and cheap, but stocks which grab their attention. 

 The reason why this approach leads to sub-par returns is because stocks which are covered in the media and followed closely by the masses are less likely to be undervalued. In addition, if you invest in the stocks everyone else is investing in, your performance will be equal to theirs; average at best.

However, you can't really blame people for taking this approach, because analyzing thousands of publicly listed companies is a daunting task. Or is there an easy way to filter out the hidden gems? I would argue there is, and in this post I guide you through my simple three step process of finding healthy, undervalued stocks to invest in.

Generate ideas

Goal: identify +-30 companies to analyze further

Finding stocks to analyze is something many investors struggle with, but it is really not that hard. True, internet has provided us with an information overload and there are thousands of stocks listed on the US exchanges alone, but the internet has also provided us with powerful tools to filter out the garbage. Using free online stock screeners is my preferred method of finding stock ideas, because it allows you to make an independent, rational selection which is not influenced by opinions and emotions of others.

Remember: although we are looking for undervalued stocks, a cheap valuation is of no use if the financial situation of the underlying company is terrible. Therefore, the first step is to determine when you consider a stock "garbage" and when you consider it a wonderful company.

"It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price."
Warren Buffett

The basic criteria I always use in this stage are:
  1. Return on Equity > 15%
    Indicates high profitability and potentially a competitive advantage
  2. Debt-to-Equity ratio < 0.5
    Implies that the company does not heavily depend on outside capital to finance its growth
I sometimes filter on is Market Cap < 1 Billion, because smaller companies are generally less closely followed by analysts and therefore more likely to be mispriced. This theory is confirmed by Ibbotson Associates, who found that Small Cap stocks significantly outperformed Large Cap stocks over the past century.

Once you have determined your criteria, use any of the following free online stock screeners and try to end up with around 30 ideas:

Google Finance
My personal favorite. A completely free stock screener with an easy interface to filter out the good from the bad.

Yahoo Finance
Yahoo offers a basic online screener as well as an advanced Java based screener. Both are free.

Fool.com
The Motley Fool stock screener is unique, because you can filter based on how well the members of their CAPS community think the stocks will perform.

FINVIZ
A popular free stock screener which I haven't used myself, but it seems to offer all the features you might need.

CNBC
This free stock screener allows you to incorporate analyst estimates and interesting financial ratios, like asset turnover and quick ratio.


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