Finding undervalued growth stocks for your portfolio is easier if you follow these tips—including spotting spinoffs and tech shares to invest in

Undervalued stocks are typically companies that have strong fundamentals and are trading, for one reason or another, at a low share price.

The best investment plans or systems use a variation of our value investing approach. That is, they revolve around choosing high-quality investments and diversifying your holdings, which may include undervalued growth stocks.

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Look beyond financial indicators to find undervalued growth stocks

When they first set out to formulate a plan, many investors decide to base investment decisions on a handful of measures. For instance, they may want to see a p/e ratio (the ratio of a stock price to its per-share earnings) below 15.0, say, along with an earnings growth rate of 20% or more annually, and perhaps a 2% dividend yield.

This approach worked a lot better in the pre-computer age, when investing was more labour-intensive. Few people wanted to dig through old newspapers, annual reports and other material to get at the data. So, more gems were left to be found by those willing to do the work.

Today, if you find a stock with this (or any comparable) combination of favourable ratios, it probably comes with some more-or-less hidden drawback not covered by your system. Instead of steering you away from investments that you don’t understand, or that harbour hidden risk, this system will steer you toward them.

Undervalued growth stocks can include spinoffs

When a spinoff begins trading, it stands to reason that investors will put a low price on it. After all, the spinoff hits the market with a large number of neutral, if not reluctant, stockholders who have limited expectations for it, and who are willing to sell when they get around to it.

One group of investors who might be willing to buy a new spinoff are value seekers. And on the whole, it pays to follow the lead of these seekers of undervalued stocks, and to hang on through months of sluggish trading while reluctant spinoff holders exercise their urge to sell.

Here’s how to spot undervalued growth stocks for tech investing

Value stocks don’t always start out as value stocks. For example, many new tech stocks start out as undervalued growth stocks and transition into value stocks. The best value stocks among them usually have “hidden value” in the form of research and development spending.

Hidden value is one of the key factors we look for when we choose stocks to recommend. By hidden value, we mean valuable assets that are not getting the attention they deserve from investors. The best tech stocks often hold hidden value that only savvy investors can spot.

When a company’s assets are wholly or partially hidden, the stock trades for less than it’s really worth, so you get to buy at a bargain price.

When we pick stocks in the more volatile technology field, one of our favourite hidden assets is high research spending. That’s because technology stocks have to treat their research spending as a day-to-day expense, much like salaries or taxes. So research spending comes out of the current year’s sales, and it lowers the current year’s earnings.

As a result, many tech stocks’ earnings per share may look lower than those of stocks in other industries. That causes some investors to overlook promising tech firms, or to see them as overpriced.

However, research and development spending has the potential to pay off in dramatic long-term returns. That’s because the products that grow out of this spending will help tech firms increase their long-term sales and profits.

We see high research spending as an especially powerful ingredient for technology stocks that will profit from a global economic recovery.

Even with high research spending, not all tech growth stocks are good investments. There are four main risk factors you face when investing in tech stocks. Below we look at ways you can minimize these risks—and increase your profits.

• Marketing is as hard as inventing: Even a great new product or computer program may fail to overcome retailer and customer skepticism. Tech stocks can have an uphill battle when they first hit the market.
• A tech stock’s acquisitions can bring “time-bomb” risk: Companies sometimes grow quickly by buying other companies. But sellers may simply want out of a losing situation. Growth by acquisition can work out, but it can also mean a waste of capital and time.
• Major tech stocks also make mistakes: Junior tech stocks often trumpet their deals with major firms, such as Apple. Apple has vastly more knowledge and bargaining clout than any individual investor. But it still invests in products that fail.
• High-tech shams are common: It’s easier to set up a company and sell stock to investors than to perfect a technological advance. Be especially wary when tech stocks splurge on elaborate websites and glossy investor brochures. 

Use our three-part Successful Investor approach for finding value stocks as well as other top stocks to invest in

1. Hold mostly high-quality, dividend-paying stocks.
2. Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
3. Downplay or stay out of stocks in the broker/media limelight.

Do you focus on an industry other than tech for undervalued growth stocks?

Have you held undervalued growth stocks in your portfolio? What was your experience with them?