Past performance is no guarantee of future returns. This disclaimer is widely used in the investment industry. Although past performance isn’t the most reliable indicator, looking at the reasons behind past performance is a good indicator for the future, I feel. Over the course of 2021, we’ve seen large rallies in stocks including GameStop and AMC Entertainment. These moves have several similarities, that I can look to take away and add to my investing checklist.
When oversold becomes undervalued
First up is the fact that both GameStop and AMC had seen falling share prices in the years leading up to the rally this year. I can bucket this into the point of stocks being undervalued on my investing checklist.
An undervalued stock is one that seen the share price fall below what would be considered a fair value. It can be the case that a stock is falling simply because the firm’s value is also falling.
In the case of GameStop, it relied heavily on the physical store presence to sell electronics. Changing consumer preferences of buying online naturally saw the value of GameStop fall as revenue dropped.
My role as an investor is to try and compute when the stock has fallen too much. I can look at the price-to-earnings ratio, and compare it to the industry average to see how it compares. If it is significantly lower, then the stock could be undervalued and worth buying.
Heavily shorted stocks
The next common point I’ve added to my investing checklist is the level of short interest. This refers to how much of a stock is being ‘shorted’ at the moment. Investors short a stock when they think the share price will fall further. They borrow shares from another investor, sell them on the market and then look to buy back the shares at a lower price. However, if the price actually rises, this can result in a loss for those that have a short position.
Both GameStop and AMC had high levels of short interest. This enhanced the rally, as to close out a position, someone who’s shorting needs to buy back the stock.
However, I do need to be careful about investing in companies that are heavily shorted. It’s a good point to have on my investing checklist, but not all companies in this regard are worthy of an investment. After all, if a lot of people think the share price will fall, there could be very valid reasons for this. So it’s risky to just use this point when considering buying a stock.
Useful points for my investing checklist
Looking at the examples of GameStop and AMC help me when building my investing checklist for the future. It shows me that targeting undervalued companies can yield good rewards. It also shows me that there is opportunity (and risk) in buying stocks that are heavily shorted by the market as a contrarian buy.
Ultimately, I should be able to add these elements to my longer list of things to look out for regarding potential stock buys to build a good overall view.
jonathansmith1 has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.