In my everyday perusal of the stock market I sometimes come across a stock whose current market value appears low and I of course wonder, "What is wrong with this stock?" A little research sometimes shows an obvious reason, but often it does not. A little more research and I can determine how secure this stock is as an investment, and if all looks good I make a purchase. Some of my best gains have come in this way.

The Problem:

The problem, if there is a problem, with investing in this manner is that it is often difficult to find these "bargains". With thousands of stock to choose from I don't have time to go through them all. So, question: How to make a quick determination on any given day as to what stocks may be undervalued? A method I have found to be quite useful is to compare the stock to the others in it's index.

A Solution:

The theory is that if ABC company makes widgets and the index comprised of all the widget making companies is doing well (i.e. people are buying widgets), then ABC should also be reaping the rewards. Low and behold after months of tracking this type of data it appears this theory is sound.

My best, unsubstantiated, guess for this behavior is due to what I would call "lag" time in the market. What appears to be happening is if ABCs clones or ABC itself hasn't yet noticed or reported the improvement, or, and this does happen, the market hasn't noticed that it has, you get lag.

The Result:

This lag period can last from days to a month, but when the market finally figures it out, and it almost always does (assuming I have done my research and can find no other factors keeping it down) my investment quickly pays off. My best analogy of this behavior is the old adage I learned in science class "Nature abhors a vacuum".


A very useful artifact of this calculation is that the short-term correction is often quite predictable. If an index is doing well but a given stock in the index is down say 5% for the past week, I can usually expect a 5 to 6% gain to be upcoming.
It also is useful to determine a relative low in the price of a stock. Lets say I have been following ABC for some time and I believe it prudent to invest in some of its shares. I want to buy when the price is low, but when does this occur. No one can tell you exactly, but when it starts to appear as undervalued in it's own index you can be fairly certain it's not going to stay down much longer.

This strategy is of course highly speculative (notice the number of time I said 'often' or 'usually' in this article) and in no way replaces the necessary research (i.e. infrastructure, financial standing, industry, the market as a whole, various trends currently affecting the market, etc.). Performing this calculation does not render a "Pick". However, as a tool, to narrow down the universe that comprises the stock market into a short, manageable list, it is quite useful.


Assuming this approach interests you then you may ask, how does an individual investor accomplish this task? Most investors already have a sector or index they follow closely and thus know how it has been performing. It is fairly simple to determine the overall trend of an index (try http://biz.yahoo.com/ic to follow indexes) and then see how each individual stock is performing. I have found it even more helpful, and much faster, to break down the individual indexes and stocks by different time ranges (ex. Index over the past 6 months and the stock over the past week) and then list these stocks on a day-by-day basis. With this daily list I can quickly pick out the potential "bargains" and get to work deciding which will be the most productive buy.


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