These Undervalued Stocks Deserve Your Attention

Imagine you are a retailer. You want to find out how many of your customers are repeat buyers and how many will never come back.

How do you find the answer?

Well, you have two options.

You either use a simple technique or you use a complex model involving lots of data points.

A simple technique could be something as basic as figuring out when the customer last came into the shop and deciding on a cut-off point, say six months, beyond which he is considered as gone for good.

The complex model will look at a lot of data points like the order history, spending patterns, demographics etc. It will then feed them into a model that will then make a prediction.

It looks like the complex model is better. It investigates a lot many data points and has been put together by experts. So it must be more accurate.

However, researchers were shocked when they found out the simpler technique or the so-called rule-of-thumb method, was better at predicting individual customer behaviour than the complex model.

Yes, that's correct. The approach of using a simple rule worked as effectively and at times, even better than the complex model.

This study, published in the Harvard Business Review, may have come as a surprise to many.

However, for the German Psychologist Gerd Gigerenzer, this outcome was entirely along expected lines.

He has been making this case for decades that when it comes to certain fields, simple thumb rules, often outperform complex statistical models.

But what exactly are these 'certain fields'?

Well, I won't be able to help you with the details but I do know is that one of these fields is investing.

That's right. When it comes to investing, simple beats complex.

Relying on simple rules of thumb and ignoring detailed, complex models can do your long term returns a world of good.

Let me explain with an example.

You see, one of the biggest challenges in investing is figuring out when to invest and in which stocks.

Again, the same two options are available to you.

You can either rely on a simple rule of thumb or build a complex model with hundreds of data points being fed into a computer to arrive at the answer.

Well, I'd go with the first option.

Here's my simple thumb rule when it comes to deciding when to take maximum exposure to stocks and in which ones.

You see, a good time to invest in the stock market is when more than 80 stocks with revenues of at least Rs 2 bn and debt to equity ratio of less than 1, are trading at a minimum 20% discount to their latest book values.

Let me repeat that. When the number of stocks that are trading below book value (minimum 20% discount to book value) cross 80, it's a good time to take a large exposure to stocks.

Here's a table that shows why I arrived at this conclusion.

Year	No of stocks trading below book value	Strike rate
2016	55	92.7%
2020	137	91.2%
2021	126	82.5%
2014	85	76.5%
2015	62	51.6%
2017	59	44.1%
2019	89	33.7%
2018	40	7.5%

Source: ACE Equity, Equitymaster

Here's how to read this table...

You see, back in the year 2016, there were 55 stocks that were trading below price to book of 0.8x, revenues of minimum Rs 2 bn, and with debt to equity of less than 1.

And out of these 55, a whopping 93% of the stocks went to give positive returns over the next two years.

Likewise, there were 137 stocks that satisfied all the criteria at the start of 2020. Out of those, a huge 91% went on to give positive returns...and so on.

Barring the year 2016, a high strike rate is associated with years when the number of stocks trading below book value are more than 80.

Barring the year 2019, a low strike rate is associated with the year when the number of such stocks are below 80.

So, here's the conclusion one can draw from this table.

When the number of stocks with a revenue of at least Rs 2 bn, price to book value of less than 0.8, and a debt to equity ratio of less than 1, cross more than 80, it could be a good time to take maximum exposure to stocks.

Likewise, when the number of such stocks go significantly below 80, it may be a good time to reduce exposure to stocks.

I know we can't make such sweeping statements based on a data of handful of years. But I think this approach does make a lot of sense logically.

A large number of stocks trading below price to book are usually seen when the broader market has fallen from its top and is itself trading at attractive valuations.

Thus, when the market recovers, the low price to book stocks also recover. This leads to a high strike rate over the next couple of years.

Likewise, a small number of low price to book stocks means the markets are expensive and could fall over the next year or two.

And this is why it may not be a great idea to take large exposure to such stocks when their number is significantly below 80.

Also, a stock does well when it is undervalued and is also of decent quality. By looking at low price to book value stocks, we are making sure that the stock is undervalued. By ensuring a debt to equity ratio of less than 1, we are also paying attention to quality.

Thus, both from the standpoint of the broader market and individual stocks, this approach does appear to be highly logical. And which is why the outcome is so encouraging.

Coming to the most important question, is this the time to take maximum exposure to stocks or to bring it down drastically?

Well, the number of stocks below book value and also satisfying the other conditions of revenue and debt to equity, are roughly around 120 right now.

Yes, there are 120 stocks that are trading at a minimum 20% discount to book value.

This means there is a strong chance a portfolio of 15-20 stocks chosen from this group, will end up doing well over the next couple of years.

Thus, if one is looking to put together a portfolio of undervalued stocks and is confused which stocks to buy, the stocks I discussed can be a good option.

Set aside 25-50% of the corpus as cash to be invested later and invest the rest in stocks that satisfy both the quantitative as well as the qualitative criteria.

In case you are wondering how investing can be so simple, well, it's supposed to be simple as I pointed out at the start of this piece.

However, it's by no means easy and often involves going against the crowd. It's this obstacle that you need to overcome.

Warm regards,


Rahul Shah
Editor and Research Analyst, Profit Hunter

PS: Talking of undervaluation, I've recorded a short video on zeroing in on the right kind of penny stocks that are not only good quality but are also attractively valued. Check it out here.