A Beginners’ Guide For Finding Value Stocks

The market has been rewarding growth, both real and imaginary, in spades. That may or may not continue for a while. Everybody is happy. There will be a time, however, where most of the growth premium in the market will either stop expanding or, parish the thought, come in. When it does it might be useful for you new to stock picking how to look at value stocks. This is a cursory look at value investing and by no means complete. Let me preface all of this with the fact that “value” as I define it is scarce right now. As scarce as I’ve seen it in years. But that will change and there will be a time when big fat pitch value stocks increase in numbers. Better to lean how to look for them know then after the juice is gone.

Positioning at least a part of your portfolio in value stocks is fundamental to anyone’s diversification design. First, in a market correction, value stocks usually have significantly less downside. Secondly, finding value in out-of-favor sectors can mean significant upside if that sector ever comes back into favor. Third, value stocks are often targets of acquisition during periods of industry consolidation and premiums get paid.

There are several ways to look at what is termed “value” in the market. People use it differently and so it makes sense to for everyone to have a good sense of what it means in what context. There’s a great article in the FT today talking about exactly that (behind the paywall, sorry.)

In the current vernacular, “value” is usually referred to stocks that are selling at a discount to their competition. While that’s generally correct I think it sometimes leads to missing many fat pitches as it tends to ignore sectors that are out of favor. When I think of value I think of stocks with good prospects that are selling near or below tangible book value. The problem with that, however, is it can be misleading given accounting issues in the value of intangibles. We’ll leave that for another discussion.

Back in the “old days” – you know, sometime before Jesus lost his sandals – the bible for understanding value investing was a book published in 1934 – Security Analysis by Benjamin Graham and David Dodd. Math, the time value of money, balance sheet and earnings health metrics and other measures have not changed since equities started trading publicly. Nor will they ever. You want to be Warren Buffett? Read that book.

I use a simple checklist when assessing a value stock.

Industry:  What industry is the company in?  Is it expanding, contracting or stable? Is it dominated by one or a few large players or does it have disbursed competition? What are the barriers to entry that hold back disruption? What regulatory changes could impact growth? None of these issues are determinative but all should be considered as you build a case for any value stock. For example, even if an industry is contracting that doesn’t mean that the strong players won’t grow. In fact, contracting industries can be positioned to shake out weak players and eventually leave both sales growth and margin expansion to those left standing. But it’s important to take all of this into account.

Business: Simply put, what does the company do? This is more important than the obvious. Most companies have more than one profit center and it’s important to know what lines of business and industries the company is engaged. How are the respective business line positioned within their industries? Is the business in multiple industries and, if so, are the product lines complementary to each other and leverage core competencies? It’s useful to think of $AAPL as both a hardware and software company. (Note: I usually stay away from businesses that cross too many industries since I think it detracts from management’s focus. That’s not always true but true more often than not.)

Management: Who runs the company? How long have they been in the position and what kind of track record do they have. What is their compensation and incentive packages? How deep is the bench? Are there any issues, such as health or litigation, that can take the management team’s eye off the ball. Don’t go overboard with this but you should have at least a cursory familiarity with management. Yahoo finance has compensation numbers as do the 10Ks. You should also do a review of the company’s 8K filings for disclosures of material changes in management.

Macro: Make sure you never buy  stocks without looking out the window to make sure the weather is stable or better. Rolling into value stocks at the beginning of a 20% correction will still usually cause losses. They may be less than the major indexes but they’ll be losses nonetheless. I’m not arguing to time the market but just use some common sense.

Financial: The meat of the matter. It’s rather circuitous but I start with a financial screen to narrow the list and then, after seeing things that meet the superficial criteria I take the make and start back at the top of the checklist.

Every trading day I run a simple screen to see if new names pop up under what I consider “value.” It involves these measurements:

  • Market cap > $300 million
  • Dividend Yield > 3% (this changes with time but nearest round number to the 10 year treasury.)
  • P/E ratio <15
  • PEG ration < 1
  • Debt/Equity < .8
  • Current Ratio > 1.5

Market Cap: I use $300M and over simply because micro caps have too much accounting risk and lack of liquidity for my taste . That’s me. Some value investors do great in that space. My luck has been spotty. If you’re new it’s a good exercise to paper trade micro caps to see how you do.

Dividend Yeild: A company with a consistent (better yet, a consistently growing) dividend indicates it likely has a consistent level of free cash flow. This isn’t always true so it’s important that the dividend payout ratio is < 1. Liquidating dividends can be, but not necessarily are, a sign of trouble but you need to know. The additional benefit to a dividend is that holds up value in a down market.  But be careful, a dividend that is far too high can also be a red flag.

P/E Ratio: I use a multiple of 15X because it’s roughly the market’s historical average. But in down markets I’ll lower that. After all, if the market is trading at 15X then 15X isn’t value looked at in isolation.

PEG Ratio: The PEG ratio is the P/E divided by the expected growth rate. I find this a good metric but it’s important to understand the limitations of the forecasted growth. The forecasts in most screens are the average of analysts projections. Still, these are as good as it gets and has proven pretty reliable for me.

Debt/Equity: I adjust this number if I’m looking for ideas in highly capital intensive sectors where leverage is supported by cash flow such as utilities. But for a broad screen I like to see companies that aren’t highly leveraged. In fact, I tend to add point to a company as their debt ratio decreases. Remember, though, don’t take this in isolation. Sometimes zero debt is bad insofar as better ROI/ROE can be achieved by employing leverage.

Current Ratio: For those of you who are unfamiliar, the current ratio is current assets/current liabilities. This shows a companies ability to pay it’s current obligations including the current portion of long term debt.  I also look at the “Quick Ratio” which is (current assets – account receivable)/current liabilities. More than anything these metrics show managements talent at managing working capital. If the numbers are too low it can mean too much short term debt among other things.

OK, that should be enough to get you started. There’s a great free screening tool at Finviz.com where you play and test various measures. Obviously it works for other fundamental and technical measures as well but I find it most useful for fundamentals and use other software for technical analysis. I also look at any stock that makes my value list through a technical lens just so I have an idea of support and overhead.

But value investing is much more time intensive than simply reading a chart. It takes me about an hour to drill down through a final analysis of any one value stock. And just like technical analysis it can be wrong. But if you hit one on the sweet spot it can pay big especially against market risk.

Over time I’ll try to expand on some of these concepts. If you’re a member of the technical analysis religion I assume beforehand that you think this is all nonsense. But first hand I’ve bought value stocks several times where the charts looked terrible and I got 400% + gains over three or four years (I’ve also had several where I lost 15% or so – buy and hold is dead.)  My bias toward value notwithstanding, I think it’s important to understand value investing as mush as understanding growth. As the environment changes it’s simply another arrow in your quiver.

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