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How to Find Undervalued Stocks

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The fundamental assumption of value stock investing is that the market is rational. Therefore, stocks that trade below what they’re worth will at any given time, will in the future reflect their intrinsic value.

Therefore, if we’re looking for value stocks, we must first find stocks that do not reflect their market values. This could be on the basis of one or more valuation metrics, such as P/E, P/S, P/B, PEG, etc. The idea is to then compare the stock’s valuation multiple with its industry and a benchmark index, such as the S&P 500. Its trading range over a certain period of time, usually a year, should also be ascertained to compare the current valuation with the historical average. If the stock has a lower multiple than in recent history or its multiple represents a significant discount from the industry or index, it would appear to be undervalued.

But that’s not the end of the story. We need to then find out whether the low valuation is justified. If for example, the valuation is below the historical average for reasons such as broader market movements; negative news flow that doesn’t directly affect the company’s business or at least, not to a significant extent; periods of cyclical slowdown that don’t in any way affect the longer-term potential of the stock; or missed estimates in any given quarter leaving the long-term thesis intact, this should be viewed as an opportunity to buy.

However, if the low valuation is for example, because of uncertainty related to its future product pipeline/prospects, if there’s a lack of futuristic thinking, if it does have a good competitive moat, if management is inexperienced, or if it is wasting too much money because of operational inefficiencies, the valuation could be justified. In such a situation, if we buy the shares simply because they are cheap, we would have walked into a value trap.

Therefore, it always makes sense to study the stocks we’re intending to buy and understand properly what we’re getting ourselves into. Here at Zacks, we can also consider the Zacks stock ranking system, which is an indication of a stock’s future performance. A Zacks #1 (Strong Buy) or #2 (Buy) rated stock always has a better chance of appreciation than stocks rated #3 (Hold), #4 (Sell) or #5 (Strong Sell). Additionally, if they also belong to the top 50% of Zacks-ranked industries, they tend to do all the better. Here are a couple of stocks that have attractive ratings, belong to attractive industries  and also have strong fundamentals:

Vista Energy, S.A.B. de C.V. (VIST - Free Report)

Mexico City, Mexico-based Vista Energy is involved in the exploration and production of oil and gas in Latin America. The company's principal assets are located in the Vaca Muerta shale formation in the Neuquén Basin of Argentina. It also has drilling and workover activities in Argentina and owns other producing assets in Mexico. This makes it Argentina's third largest oil producer and second largest shale oil operator.

According to company sources, the Vaca Muerta is the fourth largest shale oil reserve in the world and the second largest gas reserve. The U.S. Energy Information Administration (EIA) estimates that it has “technically recoverable resources of 308 trillion cubic feet of natural gas and 16 billion barrels of oil and condensate within 8.6 million acres, and it is geologically comparable to the Eagle Ford shale play in southern Texas”. What’s more, “only 4% of Vaca Muerta’s acreage has entered the development phase so far.”

The company's production efforts are primarily concentrated on shale oil, with 29,661 barrels per day produced in the Bajada del Palo Oeste block within the Vaca Muerta formation. Being in the southern hemisphere, Vista is able to supply Asian markets when they need it most.

In the first quarter, sales were up 45.7% year over year and generated earnings growth of 718.8%. Sales and earnings beat estimates by 2.2% and 32.3%, respectively.

In the last quarter, the company’s production increased 29% from the prior year. Management said that Vista Oil completed drilling pads 12 and 13 and has plans to plug 24 new wells in the second quarter, as indicated in their 2022 guidance.

Analysts expect this Zacks Rank #1 (Strong Buy) stock to generate revenue growth of 13.1% and earnings growth of 48.8% in 2023. This will be followed by 18.8% revenue growth and 25.0% earnings growth next year. Its 2023 estimate has not moved much of late but the 2024 estimate is up 12.4% in the last 60 days.

Vista shares are surprisingly undervalued. At 4.21X earnings, they’re trading at a 77.1% discount to the S&P 500 and 47.4% discount to the industry. Therefore, they’re worth snapping up right away.

Xerox Holdings Corporation (XRX - Free Report)

Norwalk, Connecticut-based Xerox Holdings Corporation has evolved from a traditional printer manufacturer to a comprehensive provider of business services and technologies. Therefore, in addition to workplace solutions like printers and digital presses and paper products, today it also offers a range of digital IT services leveraging automation and communication software through licenses and standalone software. It also provides related financing.

At the company’s earnings announcement, management talked about Xerox's strong performance, resilient demand, profitability initiatives and strategic priorities.

Xerox beat the Zacks Consensus Estimate by 206.3%. The huge surprise was despite the fact that revenue beat by less than a percentage point. Revenue increased 2.8% from the prior year while earnings increased 508.3%.

Management said that its service offerings were instrumental in supporting revenue, as they help clients navigate challenging macroeconomic headwinds including higher inflation, labor shortages and tighter liquidity conditions. There is also some opportunity to address the productivity challenges of today’s hybrid workplace. As a result, demand for Xerox equipment and services is proving to be relatively resilient.

Management has adopted a more flexible cost structure and undertaken operational efficiencies, and both factors contributed to improvements in profitability during the quarter.

The company also pays a very good dividend that currently yields 6.93%.

Overall, management outlined three strategic priorities for 2023: client success, profitability enhancement (through cost-cutting initiatives) and shareholder returns. Xerox appears to be delivering on each.

Xerox shares carry a Zacks Rank #1. While analysts expect low single-digit revenue declines in both 2023 and 2024, earnings are expected to jump 37.5% and 13.9% in the two years, respectively. Despite modest adjustment to estimates in the last seven days, the 2023 estimate is still up 29.4% from 30 days ago while the 2024 estimate is up 11.5%.

Xerox shares are trading at 8.72X earnings, which is a 38.7% discount to the industry and 52.6% discount to the S&P 500. Given their growth outlook, these shares are definitely worth buying.

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