This post was originally published on this site

Note that this research is performed between 2020-10-02 and 2020-10-07, prices could be different compared to the time of reading.

The current market is expensive, with the S&P 500 index (SPY) trading at a forward P/E ratio of 21.5x, the highest level in 20 years. Consequently, many investors are hesitant to buy stocks as they believe there are few bargains in today’s market.

It’s important to understand that the recent strong performance is, more than ever, concentrated in a small portion of the market. On the contrary, there are many stocks that are trading at undervalued levels. I believe that picking out the winning stocks from this undervalued group today will generate strong long-term returns. In this article, I will discuss three areas in the market where I believe opportunities are the highest right now, explained with some interesting stock examples in these areas.

(Source: JP Morgan Asset Management)

What happened in 2020

Significant divergences in returns

Let’s discuss the market environment in 2020 to provide the full context. Despite its weak performance in September, the Nasdaq (QQQ) outperformed significantly, yielding +29.6% year to date compared to +4.6% for the broad S&P 500 index and -2.2% for the value-oriented Dow Jones (DIA) index. This is caused by strong momentum for growth/tech stocks which are seen as beneficiaries of the economic shift during the COVID-19 crisis.

(Source: Insider Opportunities with Tradingview)

Is this divergence also visible on the individual stock level? To answer this question, I performed research on the stocks in the S&P 500 index. Not surprisingly, the year-to-date standard deviation of these S&P 500 stocks was significantly higher compared to the past five years:

(Source: Insider Opportunities research)

Even more astonishing is the histogram below, which plots the excess returns of all S&P 500 stocks compared to the S&P index itself. In normal market circumstances like over the past five years (see second graph), this gives you a clean Gauss-curve as most stocks tend to perform very similar to the market with some outliers.

However, year-to-date the market has behaved extraordinarily with extreme divergences between individual S&P 500 stocks. As you can see below, a whopping 36.6% of the S&P 500 stocks underperformed the market by more than 17% year-to-date, compared to an average 19.6% of stocks over the past five years.

(Source: Insider Opportunities research)

(Source: Insider Opportunities research)

Importance of momentum on the right side

Importantly, several outperforming stocks on the right side of the histogram did well as a consequence of strong momentum rather than underlying fundamentals.

Momentum (stock fluctuations based on fear/greed) causes stocks to be undervalued/overvalued compared to their intrinsic value (future of all cash flows discounted to today) in the short term. However, in the long term, the value of a stock always moves to its intrinsic value. Or how Benjamin Graham, legendary investor and mentor of Warren Buffett, perfectly stated:

In the short run, the market is a voting machine but in the long run, it is a weighing machine

In 2020, greediness occurred among stocks which are seen as beneficiaries of Fed interventions and the economic shift due to the COVID-19 crisis. However, in most of these cases the fundamentals didn’t change that much compared to what the stock prices indicate.

A good example is Apple (AAPL), which is seen as a big beneficiary of the Fed stimuli and the work-from-home and study-from-home shift. However, the underlying chart, which plots the stock price and EPS estimates from analysts, proves otherwise. Historically the stock price has moved in-line with the EPS revisions, but this changed drastically in 2020. Apple stock is up 51% year to date, while the EPS revisions are basically being flat. Right now investors who purchase Apple pay 24.5x the expected earnings for 2025, compared to 18.6x and 20x for respectively Microsoft (MSFT) and Amazon (AMZN), which are growing much stronger and have (in my opinion) a bigger moat than Apple.

(Source: Insider Opportunities with Tradingview and SeekingAlpha data)

Other S&P stocks which I believe got caught by too much greediness include:

  • Nvidia (NVDA): stock up 126% YTD, 2021 revisions up 28%
  • AMD (AMD): stock up 72% YTD, 2021 revisions up 10%
  • L Brands (LB) stock up 75% YTD, 2021 revisions down 5%
  • Chipotle (CMG): stock up 46% YTD, 2021 revisions down 5%

In the short term, such stocks might do well if momentum keeps being strong. However, in the long term it’s highly likely that such stocks will yield poor returns as their stock price will tend to move to the intrinsic value.

Opportunities on the left side

On the left side of the histogram, the underperforming stocks of 2020, there’s a mix of two types of stocks.

First, there are companies which get harmed in the long term by the COVID-19 crisis. For example, oil majors like Exxon Mobil (XOM) and Chevron (CVX) will suffer from a quicker transitions to green energy and lower transportation. Brick-and-mortar retailers like Macy’s (M) and Kohl’s (KSS) will suffer from an acceleration of e-commerce. The long-term potential of these stocks is limited as they become less relevant in the post COVID-19 economy. Some of these stocks look to be a great value today, but in fact are dying value traps that don’t have any distinctive value proposition.

Second, there are multiple high-quality value stocks which were unjustifiably punished by the market, which I believe will significantly outperform the market over the coming years. This can be divided into three market opportunities, which I will discuss below. In each section, I will provide a stock where this thesis worked out well already and one that I believe will provide strong returns over the coming year(s).

Opportunity #1: Overlooked value stocks not impacted by crisis

The first area in the market where I believe significant opportunities arise today are the overlooked value stocks which are not impacted by COVID-19. As stated before, the market is oftentimes influenced by momentum rather than fundamentals, which creates buying opportunities when momentum is weak and selling opportunities when momentum is strong. Or as the famous economist Keynes said:

The markets can remain irrational longer than you can remain solvent.

There are multiple value stocks which have irrationally underperformed together with other value stocks just because their sentiment is weak while their underlying fundamentals are strong. For such stocks it’s just a matter of time until the market rediscovers them, to rise significantly.

The characteristics of such stocks include:

  • A low stock price compared to the highs
  • EPS/cash flow expectations to remain similar post COVID-19 as pre COVID-19
  • Consequently a low valuation: I prefer to look at the price/free cash flow metric (cheap when <15) rather than the P/E Ratio
  • Oftentimes an increase in share buybacks and/or dividends as the management is confident in future cash flow generation
  • A high return on invested capital (>10%), indicating that the company can generate strong shareholder value (read more about the ROIC here)

Past example: Medifast

Medifast (MED) is a health-and-nutrition company which sells healthy food and nutrition packages primarily online. It is a non-cyclical business which isn’t impacted by the pandemic as people keep buying food packages online during the crisis. However, the stock was under severe pressure (-55% top-to-bottom) early 2020 as the whole market went down significantly.

Fundamentals at time of buying alert (May 8):

  • Price/free cash flow of 14.5x
  • Dividend yield of 5%, grew 50% year-over-year
  • Five-year revenue compounded annual growth rate (“CAGR”) of 21%
  • ROIC of 78.92%
  • Net cash position of $90 mln

The market rediscovered Medifast and since our buying alert at Insider Opportunities, the stock returned 72%. Medifast looks fairly valued right now.

For the second quarter, the company posted strong earnings with revenue growth of 17% and EPS growth of 6%. Its EPS expectations for 2021 were revised upwards by 11% compared to pre COVID-19 levels. The market overlooked the quality of this business.

(Source: Insider Opportunities with Tradingview)

Current example: HP Inc

HP Inc (HPQ), as most of you know, is a leading printer and PC manufacturer worldwide. While its printing business gets significantly hit by the work-from-home trend, its PC business is booming. The pandemic is slightly negative for the company, but not in proportion to the huge stock decline early 2020 of 45%.

Fundamentals at time of buying alert (June 2):

  • Price/free cash flow of 5.7x, which indicates that the company would in theory be able to buy back all of its shares in six years with its cash flows
  • Dividend yield of 4.2%, growing 14.2% YoY
  • Revenue CAGR of 3% over past four years
  • ROIC of 71.92%
  • Net cash position of $113 mln
  • Top worldwide position in both printing and PCs, grew market share of PCs from 18.20% to 22.20% and printers from 20.40% to 26.60% over the past five years

(Source: Insider Opportunities; numbers in $ mln)

The stock is up by 20% since our buying recommendations, which is only slightly better than the market performance. We believe their is much more room for share appreciation. HPQ is one of our top picks today with a price target of $32 or 70% upside from today.

HP’s third quarter results were very strong and the company guided EPS of $2.16-$2.20 for 2020, which would be only a bit lower than 2019’s EPS of $2.24. Free cash flow is expected to come in at ~$2.5 bln, significantly impacted by temporary working capital investments. Most importantly, the management increased share buybacks to $950 mln or 4% of total shares outstanding as they believe the stock is significantly undervalued at current prices. They intend to keep buybacks at this rate, indicating that >10% of shares will be repurchased each year. I believe that in the comings months the market will start appreciating the huge value that this stock offers.

(Source: Insider Opportunities with Tradingview)

Opportunity #2: Value stocks impacted by crisis, but with strong moat and long-term recovery potential

The second area to find opportunities in today’s market are the value stocks which are impacted by the crisis but have a very strong moat and thus will recover to pre COVID-19 levels soon.

The characteristics of such stocks include:

  • A low stock price compared to the highs
  • EPS/cash flow is decreasing significantly in the short term, but should be able to return to pre-Covid levels when the economy recovers
  • Low valuations based on 2019 numbers: a price/free cash flow ratio of <15x
  • A strong competitive moat: A leading position in a sector which will remain very relevant in the “new economy”
  • A solid balance sheet to weather any storm

What you oftentimes see with such stocks is that any positive sign for a recovery is directly followed by a significant increase in the stock price. Therefore, it’s smart to anticipate on any improvement.

Past example: Middleby

Middleby (NASDAQ:MIDD) is the leading food equipment manufacturer worldwide. The company sells innovative equipment (such as smart ovens, IT systems, ghost kitchens, etc.) primarily to restaurants which improves their efficiency. As a consequence of the shut down, financials got hit significantly and the stock declined 60% in only one month.

Fundamentals at time of buying alert (May 13):

  • Price/free cash flow of 9.4x based on 2019 financials
  • Revenue CAGR of 12.58% over past five years
  • ROIC of 11.32%
  • Net debt position of $1,779 (leverage ratio of 2.9x), slightly higher than we ideally would want it to be, but not risky given the strong free cash flow generation

Given their dominant position, we were sure that Middleby’s free cash flows will reach similar levels when the restaurant sector turns to normality. Despite revenues going down 39.8% in Q2 2020 and earnings vaporizing, the market reacted very positively on signs of recovery stated by the management. The stock is up 70% since our first buying alert and Middleby is approaching fair value.

(Source: Insider Opportunities with Tradingview)

New example: Korn Ferry

Korn Ferry (NYSE:KFY) is an HR consultancy company and the leader in executive research. This is a highly cyclical sector as recessions are accompanied with low demand for new employees, reducing the need for HR consultancy firms temporarily. As a consequence of the COVID-19 crisis, record high unemployment was registered and Korn Ferry’s stock tumbled by 48% this year and 65% from its 2019 highs.

Fundamentals at time of buying alert (May 13):

  • Price/free cash flow of 7.2x
  • Revenue CAGR of 13.5% over past four years
  • ROIC of 10.10%
  • Net cash position of $295 mln

(Source: Insider Opportunities; numbers in $ mln)

The stock is trading sideways since our buying alerts, waiting for any positive signal to break out upwards. Similar to the financial crisis in 2008-2009, last quarter’s earnings went negative on a revenue decline of 29%. I believe the market will react positively if any improvement in financials gets reported by the management. We have a price target of $47.3, implying 59% upside from today.

(Source: Insider Opportunities with Tradingview)

Opportunity #3: Value stocks impacted by crisis, which are successfully transitioning

The third and last big opportunity currently lies in the stocks which are impacted by the crisis, but are transitioning their business successfully and where the stock is not reflecting this improvement fully.

The characteristics of such stocks include:

  • A low stock price compared to the highs
  • EPS/cash flow are expected to improve significantly despite the crisis as the business transformation pays off
  • A low valuation based on 2019 numbers: price/free cash flow <15

Past example: Williams Sonoma

Williams Sonoma (WSM) is a US-based retailer which sells kitchen equipment and home furnishing products. Pre COVID-19, brick-and-mortar sales were still significantly more important than e-commerce. Consequently, the stock crashed 59% together with many other retailers at the beginning of the COVID-19 crisis. However, the company quickly transitioned with a much higher focus on e-commerce.

Fundamentals at time of buying alert (March 26):

  • Price/free cash flow of 8.05x
  • Revenue CAGR of 4.65% over past five years
  • ROIC of 24.28%
  • Net cash position of $73 mln (excluding lease liabilities)

We were convinced that WSM could transition its business well given its strong management team and e-commerce network. Growth accelerated with annual revenue growth of 10.5% in the second quarter and an increase of EPS by a staggering 107% as e-commerce was accretive to margins as well. The stock yielded a 121% return since our buying recommendation.

(Source: Insider Opportunities with Tradingview)

New example: Herman Miller

Herman Miller (MLHR) is a leading office equipment and home furnishing manufacturer, selling high-end chairs, desks, furnishing., etc. Last year, US workplace contracts with companies brought in 68% of revenues. However, the significant impact of COVID-19 on work environments led to a significant shift from Herman Miller to retail (home office) and online sales which are booming as home furnishing and offices have never been more important than now.

Fundamentals at time of buying alert (May 8):

  • Price/free cash flow of 8.46x
  • Revenue CAGR of 3.03% over past five years
  • ROIC of 19.18%
  • Low net debt of $30.2 mln

(Source: Insider Opportunities; numbers in $ mln)

The stock is up 37% since our first buying recommendation, but we believe there’s still a lot more upside left. Second quarter results were astonishing: EPS grew by 43.1% on declining sales of 6.6%. How is this possible? The primary reason is the fact that the retail segment (which grew from 14.7% of revenues last year to 21.4% this year) is much more profitable than the contract business (21.8% operating margins vs 15.3%). Consequently, if Herman Miller can keep transitioning to retail (selling directly to customers), profits can rise significantly. One of the most exciting parts is its expansion to gaming chairs recently through its collaboration with Logitech (NASDAQ:LOGI), which have been very successful so far. We see 29% upside from this level based on current analyst estimates, but we believe these could be way too conservative.

(Source: Insider Opportunities with Tradingview)

How to find similar high-potential opportunities regularly

All these under-the-radar, high-opportunity picks have one thing in common: They were heavily purchased by insiders. Insiders are the executive managers and directors of the firm who are in front of the financial and strategic decision making. Insiders have superior knowledge about their company compared to the market and invest money in their own stock when they believe it is undervalued. Tracking insider purchases is an overlooked investment strategy to outperform the market significantly and can be done via the SEC website or screeners like Openinsider.com.

However, it’s a very complicated and time-consuming strategy given the 100s of insider purchases each week to analyse and significant divergences between the losers and winners in this category.

Disclosure: I am/we are long KFY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.