Investing 101: Hedge Funds Love These 3 Undervalued Stocks

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Here we list stocks that appear undervalued but are signaling some bullish sentiment.

Our criteria for this list are as follows:

1. RSI (14) below 30.
2. Earnings per share estimates at a discount to market price.
3. Experiencing significant levels of institutional buying.
4. Market caps above $300 million.

If you want a closer look at these terms and why we used them, take a look at the explanations below. Otherwise, continue to the list at the bottom.

Relative strength index measures the speed and change of price movements. It is often used as a momentum indicator, with a reading that ranges from 0 to 100.

In general: RSI (14) above 70 signals the stock is overbought (i.e., prices might soon decline), and RSI (14) below 30 signals the stock is oversold (i.e., prices might soon rebound). In this article, we look at oversold stocks with RSI (14) below 30.

Earnings per share: EPS is the amount of profit that is allotted to each share of a company after dividends have been paid out. Higher EPS and faster EPS growth are both positive signs of profitability.

The P/E ratio is a widely used tool for valuing a stock. P/E is short for the share price relative to earnings per share. The ratio indicates how much investors are paying for a dollar of earnings.

P/E = (share price)/(EPS)

For this list, we used a theoretical observation about P/E ratios: If the price/earnings per share ratio is equal to some constant K, it follows that there should be a linear relationship between price and earnings per share. In other words:

If P/E = K
then P = (K)(E)

If there is a mismatch between growth rates in projected earnings per share values and price, a mispricing may have occurred, presenting an opportunity to value investors.

All of the stocks listed below have seen an increase in the current year EPS analyst projection over the last 30 days. Furthermore, every stock's price change has lagged the change in EPS projections. This indicates that these stocks may still have to price in the good news.

Yes, this approach isn't 100% accurate. There is no reason to believe that P/E should be equal to a constant at all times (that is, after all, a simplifying assumption to build a screen). But the goal here is to give you a starting point in finding potentially undervalued stocks.

Institutional investors are also known as "big money" investors or managers. They represent big pools of money such as investment banks, pension funds, mutual funds, hedge funds, endowment funds, etc. When they invest in stocks, they can invest hundreds of thousands of dollars or more at one time. These transactions, called "block trades," can have a significant effect on share prices.

Because institutional investors handle such large amounts of money, it is easy enough to assume that the big money managers know what they are doing -- or at the very least know more than the average investor. This is why these investors are also sometimes referred to as "smart money."

If institutional investors start investing in a company, regular investors can assume that some of the most talented analysts and money managers expect the company's share prices to increase over time. The stocks on our list are experiencing significant investment from big money.

Hedge funds seem to think these stocks are trading at a discount, do you agree? Use the list below as a starting-off point for your own analysis. (Click here to access free, interactive tools to analyze these ideas.)

1. Cliffs Natural Resources (NYS: CLF) : Produces iron ore pellets, lump and fines iron ore, and metallurgical coal products. RSI (14) at 24.79. Net institutional purchases in the current quarter at 9.6M shares, which represents about 6.62% of the company's float of 145.11M shares. The EPS estimate for the company's current year increased from 13.42 to 13.5 over the last 30 days, an increase of 0.6%. This increase came during a time when the stock price changed by -4.7% (from 68.12 to 64.92 over the last 30 days).

2. BRE Properties (NYS: BRE) : Engages in the development, acquisition, and management of multifamily apartment communities in the Western United States. RSI (14) at 28. Net institutional purchases in the current quarter at 11.4M shares, which represents about 15.39% of the company's float of 74.07M shares. The EPS estimate for the company's current year increased from 2.13 to 2.14 over the last 30 days, an increase of 0.47%. This increase came during a time when the stock price changed by -0.52% (from 46.05 to 45.81 over the last 30 days).

3. CF Industries Holdings (NYS: CF) : CF Industries Holdings, through its subsidiary, CF Industries, manufactures and distributes nitrogen and phosphate fertilizer products, serving agricultural and industrial customers worldwide. RSI (14) at 28.24. Net institutional purchases in the current quarter at 3.9M shares, which represents about 5.46% of the company's float of 71.44M shares. The EPS estimate for the company's current year increased from 19.79 to 21.21 over the last 30 days, an increase of 7.18%. This increase came during a time when the stock price changed by -7.25% (from 170.57 to 158.21 over the last 30 days).

Interactive Chart: Press Play to compare changes in analyst ratings over the last two years for the stocks mentioned above. Analyst ratings sourced from Zacks Investment Research.


 

At the time this article was published Kapitall's Becca Lipman and Eben Esterhuizen do not own any of the shares mentioned above.Institutional data from Fidelity, all other data from Finviz. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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