Identifying the cream of the crop trading at bargain basement prices is the goal when searching for undervalued ASX shares. Locating those overlooked and underappreciated high-quality businesses is how many wealthy investors have made their millions.
While the greats — such as Warren Buffett — make this process look easy, it can be challenging. Fortunately, the erratic gyrations of Mr Market (or Ms!) can momentarily make this task much easier than usual.
The recession panic has increased the amount of indiscriminate selling. That means some absolute long-term gems could be found among beaten-down ASX shares.
Secret sauce to finding great ASX shares
There are tens of thousands of publicly listed companies around the world. It can be an incredibly arduous task to sort through opportunities without some form of system. That's why focusing on a limited number of traits can be helpful to bring only top-tier companies to the table.
At a very high level, there are two interconnected factors that can put a company out of business — competition and funding. These two aspects grow all the more critical during cloudy economic times. The fight to survive becomes more fierce, and the funding tap runs dry.
For example, if consumers begin to drastically cut down on discretionary spending, every ASX consumer discretionary share will be competing for a share of a more limited pool of dispensable income. Unsurprisingly, much of this market area has fallen over the past year as the economy tightens.
That's why the gross profit margin can be worth checking. A company with a high gross margin — that is its revenue minus the cost of goods sold converted to a per cent — can be suggestive of a business with pricing power.
An ASX share with a thicker gross margin than its peers has more wiggle room during pressing times.
The other area of the company to investigate is its balance sheet. As Peter Lynch once said, "Never invest in a company without understanding its finances. The biggest losses in stocks come from companies with poor balance sheets."
If an ASX share has considerable cash behind it, it can fund itself even through unprofitable periods. The cost of capital plays a major role in long-term shareholder returns. For those high-quality businesses loaded with cash, their capital costs are minimal.
It will still be bumpy
The S&P/ASX 200 Index (ASX: XJO) is already up 7.1% so far in 2023. Amazingly, that means the losses of last year have already been erased for Aussie index investors. However, the year is far from over, and we have yet to discover whether the world's central banks can coordinate a 'soft landing'.
There is a chance that interest rates end up going higher than expected. Spending could deteriorate more than expected. Even though the economy appears to be on a solid footing, there are always risks that could cause it to falter… but don't confuse volatility with risk.
If you can identify undervalued ASX shares, volatility should be embraced. The impulsive nature of markets could present an opportunity to build these positions at abnormally low prices.
