There is no single approach to obtain higher returns when it comes to investing in stock markets and financial products. The best approach towards the problem depends upon the kind of investor you are and the investment style you operate with.
For investors who choose to show a more active approach towards investing, i.e. those who have time and resources to spend their attention full time on solving this problem, who also tend to have a considerable knowledge of security analysis, following approach (or some variation of it) could provide significant value. However, for a casual investor looking to invest some personal money over the weekend, who could not afford to spend considerable time to analyze and commit to a long term approach, or to the person looking to make some 'quick money' from the market, following approach is probably not the best way to proceed and there could be a more optimized way achieve her goals.
To ensure the soundness of this approach, or any approach we choose to follow, it should - 1) Always meet the objective and rational tests of soundness.
2) Must be different from most of the Investors or speculators out there.
1 - The relatively unpopular large company
Market overvalues some stocks on the basis of current extraordinary growth. In the same way, there are some companies that are undervalued by the market due to recent or temporary unsatisfactory growth. Such companies tend to be unpopular among a large set of people called speculators.
It is crucial to note that selection of large unpopular companies is important as compared to the small unpopular companies** because, by definition, such companies are not going through a very good time and it turns out large companies tend to have bigger appetite to absorb and survive such periods of uncertainties die to the brain power and cash available at their disposal. Also, once they start performing well, bigger companies tend to get attention of investors more easily and quickly.
Below table represents the return above strategy (and slight variations) compared to the Dow Index.
2 - Purchase of bargain issues
An issue is not a 'bargain' issue unless the value is at least 50% more than the price. Bargain issues are bonds and stocks which are currently undervalued and being sold at low prices relative to the value they possess.
There are two ways to check if an issue is bargain issue or not -
a) By method of appraisal - Estimate future earnings, multiply it by a factor (depending on industry or company) (now this is where Investor's research and expertise comes in) and see if that is above the current market price. If yes, then there is a chance that this potential is realized as increased revenue and increase in investors' confidence leading to more investors be willing to buy it. With increased interest, the stock price increases.
b) By estimating the realizable assets of the institution - In industries where companies tend to have huge realizable assets, like railroad companies, it is important to take into account the assets owned by the company and not just the revenue and future growth prospects while estimating the value.
In addition to above, we should place a heavy emphasis on the stability of earnings over the past decade.
3 - Special Situations or Workouts
These include arbitrage opportunities and events like company acquisitions.
People who were present at the right place at the right moment, have made fortunes by such opportunities. Considering examples like when a small firm gets acquired by an industry giant entering a new industry and looking for a jump start, or maybe wanting to eliminate future competition, or interested in acquiring IP, the acquisition has to be approved by the investors/board members of the firm and could only take place if the offered price is considerably higher than current price.
These opportunities are increasing becoming difficult to identify, specially with the rise of algorithmic trading, the thin window margin to execute arbitrage trades is shrinking even further. The job to identify such opportunities require highly sophisticated understanding and analysis of the subject and is not intended to be done by a regular investor.
Some follow-up questions -
Q. Why there are always going to be under-priced assets in the market?
A. Because the market is not 100% efficient. It exaggerates good and bad things a lot. As there are often companies with inflated values, there are also companies with undervalued price.
Q. If an asset is undervalued, a lot of investors would look out for it and invest in it leading it to not be undervalued anymore. If so, how come an asset remain undervalued?
A. This happens because investing in an undervalued asset is a risk. For instance, assets often become undervalued when people lose interest from them, lets say because of disappointing quarterly result. In our example, an investor could get good returns on it, but it's not that easy as not all companies that are undervalued gain prices. Some go bankrupt or someone takes over. The stability of earnings is very crucial.
Q. How to identify undervalued assets?
A. Big companies with current disappointing results and unpopularity. Market's failure to recognize a company's true earning potential could also lead to undervalued prices. The easiest way to identify undervalued stock is to check for the ones who are selling less than the company's working capital alone.
**This strategy is also referred as 'Dogs of the Dow'