How do you spot a cheap stock? I mean a really cheap one – a stock that could potentially double or triple your investment over the course of a year.
Well, when it comes to stocks, many investors look to buy at or near book value. That's the value of the assets that would be payable to shareholders if the company was stripped apart that day. And on the face of it, that makes sense. If a company goes bust, an administrator can sell the business assets, repay any loans and still give you your money back.
But there is a much more reliable way to find a cheap stock. And I've used it to spot a seriously great opportunity that I've been following for months. I'll tell you how I think you find a stock like this today. And I'll follow up by letting you know more about this stock early next week.
You have to forget what the FTSE 100 is telling you
How many times have you checked the FTSE 100 this week? I bet it's a few. Most investors in this country have a pathological fascination with the index. But that's not such a good thing.
The trouble is that the FTSE is quite a strange beast. Our FTSE 100 is a basket of multi-national companies that produce decent cashflows. Even the banks mostly produce enough cash to keep going despite large headline losses. These companies have access to finance – Unilever, for example, just issued a $US bond paying a remarkably low 0.45% p.a. So the FTSE paints a very rosy of picture of what's going on.
Other stock markets attract different sorts of stocks. As a keen resources sector investor, I know that the Toronto Venture Exchange (TSX) is a place for speculative junior mining and exploration stocks. And right now, things aren't looking good in that part of the world.
Here's a chart showing the FTSE 100 (green line) against Toronto Venture Exchange 30 (black) over the last year.
FTSE 100 vs TSX Venture 30
Put bluntly, the markets hate junior mining and exploration stocks right now. Why? Well, the problem is that the sector is so hated that it's all but impossible for many companies to raise capital. And these sorts of stocks nearly always need funding. Even if they make a discovery, they'll often need funding to bring the prospect into production. And no discovery means they'll want money to continue their operations.
In many ways, this funding issue is another symptom of today's dysfunctional capital markets. Though the authorities are pumping cash into the banks, there's little appetite for them to re-invest the proceeds into something useful like exploration. They'd rather put it down on government bonds or Unilever and get a dismal 0.45% a year. As a result I think commodities will continue to suffer supply problems.
But it's not all bad news...
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The 'lottery ticket' I was talking about
So the tide is out on the TSX. Under-funded companies have been pummelled by the market, and it's dragged down the better funded companies too. It's a matter of sentiment.
But that provides us with a great opportunity. I mentioned earlier that it's not always a good idea to pick a stock based on its book value. That's because it's rare that a bust business gives anything back to equity holders. Often the assets can't be sold for anything like book value and the administrator clocks up a big fee trying to unwind the business.
But cash is a different matter. A company that has significant cash on the balance sheet is in an enviable position. And if you can find a stock that is trading below it's cash balance, then you have a very nice opportunity.
Take junior miners and exploration firms quoted on the TSX. Many have enough funding to keep them going or quite a while, but their stock prices have been dragged down by poor sentiment.
But there’s no doubt, that even with cashed-up explorers, these can be risky plays. Though the firms make a calculated assessment of where and how to explore for resources, ultimately there's a large element of chance. Will the first wildcat drill find oil? Or are they going to have to drill 20 wells, before anything shows up? For an investor, this game of chance can be exciting and lucrative, or gut-wrenchingly costly.
But if they have significant cash, then that's not such a problem. And with the tide out, there are at least some great opportunities among miners and explorers at the moment.
So look for stocks that are trading close to, or below the value of cash. And this cash must be sufficient to keep the company in exploration for over a year. But most importantly, the firm must have decent prospects – a series of prospective oil wells to be drilled; a rich gold seam that can be mined.
And I have been following one particular oil explorer for over a year now. I've been building up an understanding of how the business operates, how much money it spends and assessing its prospects.
What's more, I've followed the stock as it's fallen from around $10 to $1.30. Do you remember how I told you never to invest in a stock when it's first tipped? Follow it and understand it first. Well, this is an example of just that.
And at $1.30 this stock is trading below the value of its cash. I reckon there's well over a year's worth of funding for its impressive drill schedule. What's more, the firm has already found gas that it intends to bring into economic production. But the market doesn't care.
Next week I'll let you know more about this company. It's traded on the Toronto Venture Exchange – so any investor would need a broker that trades this market if they wanted to take part. This will be a risky punt. It's a cross between an investment and a lottery ticket.
That said, a lottery-type win could be on the cards. I'm quite excited about it, and I've been patiently sitting on the sidelines watching and waiting for when I believe is the right moment to buy.
I'll let you know all about it next week.
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