Three undervalued stocks to buy now

Each week, a professional investor tells us where he'd put his money.This week: Tristan Chapple of the Aurora Investment Trust.

We agree with Warren Buffett: "it's far better to buy a wonderful company at a fair price than a fair company at a wonderful price". Among the criteria we think make a business "wonderful" are a high return on capital (15% or above), pricing power, and enough predictability for us to assume the company will be in business for many years to come. We also need to understand why the business can earn such high returns and then monitor its progress closely over time. Ultimately, delivering excellent long-term investment returns requires patience. Here are three examples of companies that we currently believe have strong prospects but are undervalued.

Pharma's continuous domination

A study of the history of the pharmaceutical industry reveals a perpetual cycle of research, drug discovery and patent expiry. Although the world's great pharma businesses tend to endure, their most important products rarely do. Today's largest pharma firms were equally dominant during much of the 20th century. They are some of the worlds' most effective and resilient industrial enterprises, with scale and distribution capabilities that are difficult to usurp.

GlaxoSmithKline (LSE: GSK) continues to reshape itself, as a suite of new pharmaceutical products replaces those of the past. Furthermore, the consumer healthcare division has similar characteristics to a branded fast-moving consumer goods business and serves a market with great long-term demographics as consumers increasingly use the internet to educate themselves and self-medicate. The vaccines business has unusual, significant, and sustainable barriers to entry and hence pricing power.

Two resilient firms in tough markets

Over recent years, leading engineered ceramics firm Vesuvius (LSE: VSVS) has been doing a good job in difficult markets, which are now showing signs of improving. Interestingly, while the fluctuations of the steel market have some impact on the business, it is not as important as may be first assumed. Unless you completely decommission a steel foundry, then even if steel production volumes fall substantially the steel manufacturers still need the perishable steel production components that Vesuvius produces.

The business is well managed and has used sensible self-help measures to cope with the market conditions of recent years. And now there are plenty of signs that the underlying consumer demand for steel products (such as cars, for example) continues to be robust.

Lloyds Banking Group (LSE: LLOY) is an interesting case because the business fundamentals have been improving for some time and yet the shares remain cheap. It is a good example of why it pays not to stick one's neck out and talk about when and why a share price might start to rise. Since 2010, the balance sheet has improved considerably and the group now has a class-leading capital ratio, far fewer unwanted legacy or "run-off" assets, and much less reliance on wholesale funding than in the past. The management team have been reducing the cost base (by closing underperforming branches, for example) and simplifying the operating model. Meanwhile, the business continues to enjoy high market shares and strong underlying profitability.