How To Spot An Oversold Stock

When the market is volatile and the cruel hand of fate deals your portfolio's best-performers a blow, it's a natural instinct to wish to sell -- and many investors do. However, this could be a unique opportunity to get more stocks at a discount.

The COVID-19 downturn and the inflationary woes facing the current market have both shown that many household names can suddenly fall in value. Some of the stocks some might consider 'oversold' include Apple (NASDAQ: AAPL), Warren Buffett's Berkshire Hathaway (NYSE: BRK.B), and The Trade Desk (NASDAQ: TTD).

Many of the more hype-driven investors among us might also argue that 'meme stock' members Tesla (NASDAQ: TSLA), Beyond Meat (NASDAQ: BYND), GameStop (NYSE: GME) and their ilk are also oversold. It's all a matter of perspective.

What is an oversold stock?

The term 'oversold' refers to when an investor believes a stock is being sold 'too much' among traders for numerous reasons. Unlike a market correction (falling 10%), or turning bear (falling 20%), there is no number or threshold that can confirm when a stock has been oversold. It is simply down to the opinion of the individual investor. However, there are generally some factors that play a part in a company's sudden downturn that leads to a widespread sell-off, even when its business fundamentals haven't changed:

Investors reacting to one negative aspect of an earnings call, such as lower-than-expected guidance, despite an earnings beat.
It could have fallen afoul of the media (think of when Starbucks got in trouble for alleged racial bias).
Maybe the market is just in a bad spot and dragging the stock down with it, as we are witnessing now.

Does this represent a buying opportunity?

In situations like this, the company has not changed its core values or business model. An oversold stock is considered cheaper than it should be and can be a great opportunity to get a favorite stock at a discount price, though the oversold condition is not an automatic buy signal.

There are two types of approach to identifying oversold stock:

Fundamentally oversold

A stock that investors feel is trading below its true value. For example, a company like Disney (NYSE: DIS), which fell 15% in a month durign the onset of the coronavirus, did not suddenly become a different company. It is still the same media giant that demolished box-office records in 2019, brought out a hugely successful competitor to Netflix (NASDAQ: NFLX), and has seen billions generated from theme park growth over the past decade.

So why was the stock down? Simple: the coronavirus was hurting its top line at the time through park and cinema closures. All of these things are temporary setbacks, and Disney will be back up and running eventually (once we get through the market's current inflationary woes). In the past 12 months, its stock has fallen almost 40% in value. Is it worth 40% less now? Well, that would be up to you to decide...

Technically oversold

This is when technical analysis is used to define if a stock is oversold or not. The most well-known model for this is the Relative Strength Index (RSI). A technical indicator only looks at the current price relative to prior prices. It does not take into account fundamental data, but analyzes Average Gains and Average Losses to measure the speed and magnitude of price movements.

The RSI is always between 0 and 100, with stocks above 70 considered overbought and stocks below 30 oversold. For a brief period in February of 2021, Microsoft (NASDAQ: MSFT) was considered 'oversold' by this index, for example. However, this sort of thing is pure technical analysis, and is best steered clear of by the average investor.

What to look for...

Finding an 'oversold' stock is all a matter of opinion, and depends on your own value of a company, and whether you think it is representative of its stock price. When investing in any company, you should already have a solid understanding of its fundamentals, including how it's run, who is running it, its mission statement, historical performance, and if you even believe in it.

If you're looking to spot an oversold stock as a buying opportunity, then you need to consider the facts yourself, and if you truly believe a stock's fall is warranted. You can also try using an RSI indicator or similar tools. In the end, though, it's all down to your own valuation.