I had noticed a certain reverence in the demeanor of the mostly male guests on the Wall Street Week of the 1970s whenever Warren Buffett was mentioned, host Louis Rukeyser included. When the discussion moved to Buffett and the talk moved to “value stocks” you could detect a change of vibe almost as apparent as a change of studio lighting. Such a topic must be approached with the deepest respect is the message I got when I used to watch the show as a teenager working in the videotape room of University of North Carolina Educational Television. It ran on Friday nights just after The Creative Person, a wonderful unintended contrast of two worlds.
That was the context for my first exposure to the value stock universe: it’s that subject that comes right after poets, novelists, musicians and artists and just before the weekend. What I have to say about what I’ve learned about it starts there.
A couple of years after watching Wall Street Week every Friday night, I picked up a copy of the Graham and Dodd book and taught myself as much as I could understand. I got this much: if you studied financials, sometimes you could find stocks worth more than the market price. It reminded me of when I bought 45 rpm records from a wholesale record distributor in Brooklyn for 59 cents and sold them to my Teaneck, New Jersey junior high school friends for 89 cents. Oh, now I see.
It’s the same basic principle: buying what can be identified as cheap and selling it to others at a higher price which, in the case of stocks, means later as in after a period of time. It sounds simple but there’s a lot of work involved to get there. Or, you can skip it and try your hand at growth stock investing, a method much more popular lately. Value stock analysis is a long walk through metrics that were used as long ago as the 20s and 30s – old school, to be sure, but, to me, that’s the beauty of it.
When I started becoming interested as a teenager, I didn’t realize that the market could be divided up into types or categories of stocks. I had the standard outsider’s view that the main thing was the company story and the strength of the brand: GE made good light bulbs, must be a pretty good stock. IBM made big computers, must be a decent investment. Chase Manhattan is a huge bank in New York City, must be the way to go. It didn’t dawn on me for years that digging deep into financials could be telling in a way that wasn’t apparent on the surface.
The Meaning of Value.
Every stock is a value stock of some kind. You could say that there’s “value” even in the riskiest of businesses based on the wackiest of ideas – the value is present in the potential for great reward. Emphasis on “the potential.” The problem is most companies like this eventually go out of business and it’s usually sooner rather than later. A select few garner huge rewards, but that’s rare. Mostly, high risk, unhedged and over time, gets murdered.
But when seasoned investment analysts mention the word “value” as they’re ranting away on CNBC about stocks, they’re referring to something specific and it has to do with less risk, not more. A value stock has value when it meets a certain set of criteria that indicates the current market price is less than its intrinsic worth.
To de-mystify: you can buy it cheap. That is, relative to most other stocks. Sometimes they call it “break-up value” – if you broke it up into pieces and sold everything, you’d get more than the current non-break-up price tag. Sometimes they use the term “undervalued,” but among the Wall Street knowledgeable, that just means value stock.
Value stock, undervalued situation, breakup value, cheap. These are the terms used to describe what you end up with if you analyze companies the way that Benjamin Graham did when he was teaching business classes at Columbia University long ago. Call it whatever you want, add any nuanced details, that’s what’s being discussed.
Along with identifying value, these methods generally keep the investor away from potentially hazardous situations based mostly on expectation. Generally. You won’t be looking for “explosive earnings growth” or “disruptive innovation.” It’s the opposite: value stocks tend to be old, boring and not much fun to tell your friends about.
Here is the mix of metrics you’ll need, for the most part, to clearly identify this kind of value in the stock market, if that’s where you want some of your money to go: price/earnings ratio, book value, earnings growth, debt to equity ratio and dividend payout.
- The price/earnings ratio.
The p/e is the market price of the stock divided by the amount of its yearly earnings.
A company earns a dollar per share. The stock is trading for 10 dollars a share. What’s the price/earnings ratio? I got 10. That’s low.
A different company is earning 10 cents per share. The stock is also trading for 10 dollars a share. What’s the price/earnings ratio? 100, right? That’s high.
Right away, without thinking about it too much, I can see that the second company is being priced more on expectation than on current results. That’s the most common, likely explanation — although a few others could be possible. All of the analysts over at the growth stock desk can’t stop talking about how amazing the future earnings are expected to be, why it’s probably the next Amazon or Apple, if you look at it in just the right way, you definitely want to buy at least several thousand shares before next Tuesday’s sales report, what are you waiting for?
But if we’re thinking like a value investor, we already prefer the first company with the much lower price/earnings ratio. The business it’s in puts us to sleep with the stupefying dullness of its operation, but the thing is: we can pay substantially less for more actual earnings, earnings already sitting in the bank, waiting patiently for their turn to become the cheerful part of a dividend check. It’s cheaper, according to this single measure – a simple analysis which obviously requires much further work. We’re just getting started. Context is important.
Nonetheless, this beginning step to examining how much in earnings we’re receiving for the price we’re paying is essential once we take this classic analytical path.
By reducing the number of stocks to analyze using the price/earnings ratio, we are separating the wheat from the chaff. Although a number of other screens are necessary to pinpoint worthwhile value stocks, this first step helps to diminish the taint of “expectations” from potential investment candidates.
It greatly moderates the list and, in general, helps to keep us away from speculative stories based on the imagination. Not always, but for the most part – that’s why looking at a few other metrics is required. As a basic rule, a list of those stocks with p/e’s below the market p/e gets us on the right track to value. Significantly below is even better.
What’s the “market p/e”?
For most purposes – and our purposes – that’s the price/earnings ratio of all stocks included in the Standard and Poor’s 500. All of their earnings added up and divided by 500. It’s the generally agreed upon benchmark against which all p/e’s are measured. Some smart analysts with economics degrees adjust somewhat for inflation and cycles, but since we’re looking for significantly lower p/e’s, we don’t need to worry about it.
If you were only looking at small capitalization stocks and ignoring the big ones, then it’s the price/earnings ratio of the Russell 2000 “small cap” index that might more appropriately fit. Since a significant number of small caps have no earnings at all, this one’s tricky.
If you were only considering very big capitalization equities, it might be enough to start with the p/e of the Dow Jones Industrial Average. The drawback is the fact that the DJIA consists of only 30 stocks. They’re all big companies, but is that number enough to begin to make judgements? Context is important but the main thing here is to make sure the stocks you’re looking at are trading at valuation levels lower, much lower if you can find them, than their peers.
When you begin to hunt for price/earnings ratios on the Internet or in financial print media, you may find different kinds of p/e’s listed. Find the one that indicates what the earnings were for the last year – don’t make the mistake of making a case from “estimated earnings for next year.”
“Projected” earnings or “expected” earnings are interesting but mostly irrelevant when you’re analyzing for value stocks. We’re interested in what is not what might be. Skilled analysts with fine investment firms spend a lot of time coming up with figures like “expected earnings” but they’re not looking for the kind of stocks we want. That’s the pursuit of “growth” not value, a much different game with its own set of rules.
Once you start examining the p/e’s of many stocks you’ll begin to notice that certain types of industries fall into the “low p/e” category and certain others fall into the “high p/e” category. For example, right now – in general – many technology stocks and Internet-related stocks will end up on the “high p/e” list of those we want to avoid. Not all, but many. A lot of expectation is built in to those companies and that’s fine if it develops, but we want only established, recorded earnings. Because of their non-tech orientation, lower p/e stocks tend to generate less media coverage.
How much money would you pay to own a company that’s making money?
That’s the question answered, partially, by determining the price-to-earnings ratio of a publicly traded business. The vast multitudes continuously buying and selling stocks put a market price on the amount of earnings.
The poker analogy is to bad opening hands that you must fold because there’s not any point in continuing, the odds of hand value are that bad. In Texas Hold Em poker (see Matt Damon and John Malkovich in the movie Rounders) the worst first two cards you can be dealt are seven and two. Mathematically, this hand really stinks, the correct play is to fold. You might get lucky, but that’s all it would be: luck. If you are dealt a pair of Aces, the odds are good, in fact that’s the best hand possible and the practice is to continue with that combination. These price/earnings metrics help you to decide quickly when to fold and when to continue. Doyle Brunson is highly likely to be folding high p/e stocks.
- Book Value.
Book value is what you come up with when you add up everything that counts as “asset” and subtract from that everything that counts as “liability.” Book value per share is that figure divided by the number of shares outstanding.
Typically, in the modern era, stocks trade at greater than their book value, usually much greater. If I were a historian of the future, looking back on this, I’d put “much greater than book value” on my list of measures of decadence. Back in 1934 when Benjamin Graham and David Dodd wrote Security Analysis, many stocks traded at much less than book, a major consequence of the Depression era. Eventually these stocks found buyers as investors began to gain confidence in the economy and noticed the value, but that took time.
“Much greater than book” = careening off the hook, caution. “Much less than book” = might be overdone on the downside, take a look. More or less. From the value perspective.
At the time that I’m writing, not many stocks trade below book value. They exist but it’s not like the 1930s. These days a company that you can buy for less than book is likely to have some serious issues — sometimes related to a perceived inability to continue earning money, often associated with high levels of debt. When Graham was teaching at Columbia and writing classic investment tomes, you could find dozens and dozens of well-run, exchange-traded businesses available for bargain basement prices. The list of such companies today would be short and you would quickly notice, examining other metrics, how questionable their future prospects looked.
In short, value stocks trading below book value always exist. You may live in an era when they’re tough to find and largely ignored. You may live during a Depression and, if you have any money, have the good fortune to discern the value then present. Either way, since you’re picking up assets for less than they’re worth – and which seem to have otherwise solid businesses – you can sleep knowing that value is eventually recognized and respected. The discipline requires sitting through longer-term fluctuations and remaining confident in a method that identifies the attractiveness and validity of discounted price.
Calculating book value is uncomplicated. First, you come up with shareholder’s equity by subtracting debt (or liabilities) from assets. From that figure, subtract preferred stock amount if preferred stock is on the books. The number that you find on that bottom line is book value. If it’s less than the market price for that stock, that’s interesting.
All of this information is available in the annual report of exchange-traded companies and it’s often in quarterly reports. Better yet, it’s reliably reported by those investment websites who track stock markets: a good one that I’ve used is Financial Visualization at FinViz.com which lists many different balance sheet metrics of almost all listed companies.
What you have to be careful about when analyzing for value: the metric “book value” is subject to more interpretation than you would think. Companies with equipment are required by the standards of accounting to depreciate the cost of machinery, for example, at a reasonable rate. Or it may be the case that real estate on the books is doing the opposite, that is, appreciating.
Most balance sheets reflect decent, honest work but sometimes you will encounter attempts to stretch things. Once you begin to examine these figures you may develop a sense for what smells right and what doesn’t. It’s important to be disciplined with the approach — it’s also important to keep your eyes open to artistic approaches in some numbers crunching. Using book value as a metric for the selection of stocks requires some skepticism about financial reporting: some legitimate companies have creative ways of determining asset value.
One other thing: book value tends to favor those companies with solid physical assets like railroads or solid patented assets such as pharmaceutical companies. This figure tends to be low for the type of companies that don’t necessarily require either of those: like some Internet-based companies or advertising firms or any publicly traded non-traditional outfit without much need of physical machinery or patents.
- Earnings growth
Checking earnings per share is the quickest, most basic and essential way to see how a company is doing. Are they earning money? Have the earnings increased over this time last year? Are they making more now than, say, 3 to 5 years ago? If earnings dipped and rebounded, can it be said that they’re growing? If the answers to these series of questions is yes, then it’s interesting and you can add it to the list of potential investments. Amazing, extraordinary or outlandish growth is not absolutely necessary here – if it’s seen, then fine, but that sort of thing is generally left to growth stocks. With value stocks, even a little bit of earnings increases is worth considering.
No “projected” earnings or “expected” earnings are allowed if you’re doing the work to identify what is traditionally known among Wall Street analysts as value. Future earnings guesses may be appropriate, done correctly, for growth stocks but those estimates don’t belong in this approach to the market. Is the company profitable now? Has the company managed to show profits steadily and recently? That’s what needs to be confirmed and it’s without reference to guesses about next quarter or next year. No expert guessing is allowed with value stock analysis — that kind of risk-taking may be appropriate with other methods, but not here.
Since the basic idea of investing in value stocks is for the long-term, it’s probably mostly a waste of time to take a look at the quarter-by-quarter earnings per share that find their way daily into the business media. For one thing, the shorter-term stuff can be manipulated by clever but not necessarily illegal accounting tactics – sometimes designed to beat a short-term forecast. These tend to receive “adjustments” later. This kind of trickery can’t be avoided entirely but it’s generally possible to lessen the effects by sticking with the year-to-year results and by verifying that all of the other value metrics are hitting the proper marks.
- Debt to equity ratio
If you’ve got a job and you’re earning money and you want to borrow funds to buy a house, at some point you sit down and figure what percentage of your income can go, reasonably, to a monthly mortgage payment. That’s the essence of debt to equity. It’s an imperfect analogy to the financial statements of publicly traded companies, but you get the idea. The basics are easy to understand: what’s the relationship of money flowing in as opposed to the amount that’s been borrowed and must flow out? Is it too much or within reason?
Long term debt that exceeds 50% of equity is too much. That’s the wisdom of the ages from the value stock analysts of legend. If shareholder debt-to-equity is less than 50%, that’s reasonable for stocks to be interesting. All stocks have risk, but one of the ways this method reduces that risk is to eliminate from the list those companies with debt levels that go beyond comfort levels.
Short-term debt’s a little bit different, but the same thinking applies. Basically, it’s good for value stock consideration if there are more assets-to-liabilities on a previous 12-month time frame. More short-term liabilities than assets would suggest caution depending on the strength of all of the other metrics. When Ben Graham was analyzing stocks in the early 30’s, he’d find some with more actual cash than liabilities, a very good situation but exceedingly rare in the modern era. CEO’s are questioned who fail to put cash to work and let it sit in the checking account – it’s considered poor use of the stuff these days.
The “current ratio,” as it’s called, is that amount of assets on the books versus the amount of liabilities that must be paid within 12 months. The classic recommended ratio – from Benjamin Graham days — is 2 to 1 but, generally, it’s basically good to simply see more current assets than current liabilities. That debt can be paid off with money to spare is widely regarded as a good thing. If short-term liabilities are greater than short-term assets, you would want to wonder what the reasons for that are. Or, better yet, remove it from the list and move on to find other potential candidates.
It’s like accumulating a lot debt in your personal life. It’s not too bad if you have some debt especially if you’re earning money and have the ability to keep paying it off. If you take on too much debt and you begin sending more and more money off to the debt-holders, it can get difficult. It’s the same basic thing with companies. A lot of factors may be involved but, the main thing is: you want to avoid a situation where the debt-to-equity is more than 50% — above that tends to make it hard to make money. Generally speaking.
- Dividends.
It’s not so much a metric as a fundamental sine qua non for the screening of value stocks. Simply put, if it pays a dividend, it can go on the list of potential candidates. If it doesn’t pay a dividend, then it fails to make the list.
That leads us to the importance – and dare I say “value” – of finding and staying with stocks that pay dividends. Since you’re in it for the long-term, it’s nice to be receiving payments, steadily, while you wait. This is another of those annoyingly obvious statements to value analysts but which tends to float quickly past the “I just want the price to go up right away, I’m in a hurry” crowd. Not only is it gratifying and pleasant to accept dividend flows, it shows respect by the business owners to their investors. Thank you for your investment in us, here’s a check to show how delighted we are to have won your trust and confidence.
In some cases, a point comes where the yearly checks may begin to approach the original cost of investment, a nice outcome which requires a decent-sized yield and a great deal of patience. Or, to look at it another way, each dividend reduces the original cost steadily, payment after payment. It’s not the most exciting way to achieve success, it lacks the glamour of the wonder called “disruptive innovation,” but it feels good years later when the effects of several business cycles have kicked others to the curb and your checks keep arriving faithfully.
This is thought of by many as an old fashioned, possibly out of date framework for analysis in what passes for the modern era of Wall Street quantitative deep thinking. “He’s talking about restricting investments to only dividend paying stocks? Are you kidding me?” No, I’m not kidding. I mean it — if what you’re looking for are value stocks as the term is classically defined. When you cut out the non-dividend payers you cut out many tech stocks – but that area of growth-oriented investing is approached correctly with other methods designed to keep risk comfortable for those who want to go there. That’s different. We’re just looking for value in the old-school sense, so a dividend payment is part of the plan.
My Apology for Bringing Math into It
Please allow me to apologize for bringing up annoying terms like “ratio” and “metric.” As much as I hate these words and all they connote, I’m afraid it’s unavoidable usage if we’re talking about the analysis of business financials. It would much more fun to drop “innovative” and “disruptive” into the discussion and to focus on the fascinating personalities of hotshot chief executives and their “philosophies” but all of that is deflection from what’s important to determining value.
Dividing one number by another gives us what we want here and even though it’s tedious math, I like where it takes us. True financial-math geeks these days are writing mind-bending books about algorithms and the ghost-like hidden variables of complex systems. Great. We’re just dividing numbers. I apologize for going to any kind of math – if it weren’t necessary, I’d skip it, but it’s necessary. On the plus side, I’ve avoided equations, derivatives and theorems entirely.
Studying Numbers.
After all of the metrics have been analyzed and the resulting screen shows a list of stocks, you get to bring your judgement to the task. Which of these candidates look right? They’ve made it through a rigorous test of their merits based on the classic valuation method employed for decades by thoughtful, careful money managers. Now that you’ve gone through that process, you can take the list and start reading up on the managements and their businesses. You’ve started with the analysis of the numbers. That comes first. Then, once that’s done, you can begin to examine what lies behind them. Now that you’ve got the right numbers, how does the narrative strike you? Are there videos available where you can see the CEO talking about his company and the business? Find them. What’s the vibe?
This is the opposite of the approach typically taken by most when it comes to the stock market. Often, money goes to what simply seems like a “good idea” or to something a business associate or neighbor suggested. The beauty of studying the numbers first is that it helps to prevent or to at least diminish the emotional attachment which tends toward poor results. When you’ve researched for p/e, book value, earnings and debt, you’ve begun to significantly reduce your chances of making a stupid mistake. It’s impossible to eliminate risk – you need it for reward – but the concept here is to begin to manage it by sticking with only whatever adds up to value.
This is the other side of value stock investing – other than finding cheaper-than-their-worth – if it’s done correctly, risk is reduced compared to other methods. The type of stocks that will end up on your list are unloved and widely avoided. It’s usually because the industry they’re in has hit near the bottom of that sector’s business cycle. Or because a bad several quarters of earnings has freaked out the crowd even if the fundamentals remain basically strong. Since bad news is already reflected in the price, the odds are decent that risk/reward is favorable. That’s the idea – again, if the method is followed carefully.
No guarantees exist. All that value investing guarantees is that you’ve put your money in an apparently decent business that temporarily is being offered for sale on the cheap shelf. A diversified group of such stocks might help to mitigate the risk that any one or two of them stay undervalued for a lifetime (a “value trap”). But you are excluding money from the wildness of risk that overtakes the markets when so-called hot stocks of the day begin to collapse and fade during inevitable sell-offs. Value stocks tend to be cool stocks hanging in the back, waiting patiently for their day while sending out cashable dividend checks.
Value Stocks Are Boring.
After you’ve spent some time learning and understanding the method and the metrics involved and you’ve screened for a few of these stocks and you’ve seen what they do and what businesses they are in, you may be disappointed in what comes up. When you look at the list, if you are unexcited by the names, don’t hold back, you’re probably on the right track. That’s how this works.
Typically, these stocks are boring especially if you’ve been following the business media as it excitedly and enthusiastically follows hot technology stocks, cryptocurrencies and the entire hyped-up cult of disruption and innovation. The stocks on the value list tend to be in old industries involved in less than thrilling endeavors. That’s a characteristic of most value stocks, don’t be surprised at how boring. I wish I could say that’s it’s all terribly exciting, but it’s not.
Value Traps.
To avoid the selection of what have come to be called “value traps,” make sure the business you’re looking at, though old and boring, is not on the way to becoming completely out of date. The classic example of the 1990s versus now is the steady replacement by digital technology of DVD’s. A manufacturer of material that you know for certain to be headed toward obsolescence – if you see that on your list, scratch it. At this point, it’s not just the metrics, you have to look coldly at the nature of the goods and make a judgement.
Another possible sign of a value trap is that the business is based on a single product and nothing else. In general, to lessen the risk of this trap, it’s probably better to find companies involved in at least some diversification of what’s made and sold.
The Personality of a Value Investor.
Generally speaking, when a growth investor shows up, it’s probably in a Tesla or Jaguar complete with a unique name license plate. The value investor is still driving that old Toyota Corolla, it’s in fine condition, might need an oil change. A growth person enjoys trips to Las Vegas, stays at Bellagio and knows more than just the basics of Texas Hold Em poker.
A value person, on the other hand, enjoys playing bridge with a few friends and neighbors and makes it a point to visit National Parks like Yellowstone and Mesa Verde during family vacations in the summer.
Generally speaking.
A value stock investor has to be willing to sit still and do nothing. Such stocks must be purchased when most others are avoiding the stock or just avoiding the market as a whole – the investor has to take confidence in the method. Typically, the negative news is out there and the stock is cheap because so many have left it – going against the crowd requires steeling oneself against the prevalent mood, not always easy. It’s the opposite vibe of “the latest thing” where the subject is always being discussed in the business media. You’ll be looking at rarely mentioned issues. It’s an adjustment.
Value stock owners are holding the stock and waiting for the time when the market finally recognizes the, well, the value. Patience is required. That’s one of the reasons that the master, Benjamin Graham, insisted that only those companies paying dividends be included on the list. Since you may be required to wait at least you’re being paid for it. In addition, it’s one of those items that tend to add up to “healthy business” if it’s sending out regular, quarterly checks, however small, to stock holders. The likelihood of “quality” is there.
The market can take a long time to recognize the value, sometimes it takes many years. You miss exciting investment themes of the day – the stuff that all of your friends are talking about when they talk about stocks or markets. You’re required by your discipline to listen to them patiently while you either nod your head or change the subject. You’ve become quite knowledgeable on several boring stocks that no one wants to hear about. You mention that dividend yields are now above Treasury bond yields and everyone begins to move away from you. That’s okay, they’ll be more interested after the next business cycle ortwo.
Welcome to value investing.
All Value Stock Information Can Be Found on the Net.
You don’t need to go through annual reports or quarterly reports the way the old guys used to do It back in the Fifties. I mean, you could if you wanted to, but it’s no longer necessary. These days, all of the information you need is up on the Internet, so if you have a connection you should be able to construct lists of stocks. I use the “screener” device found at the Financial Visualization website, FinViz.com. This allows you to build screens based on price/earnings, book value and all of the other metrics I’ve mentioned.
I also screen for “average daily volume” of over 300,000 shares to make sure enough liquidity exists – fewer than that and you might have to wait to unload all of the shares on certain days. Typically, you’d want to be able to sell easily, all at once without delay. By committing to heavily-traded stocks, you make this possible.
I also screen for only exchange-traded issues: that is, those companies whose stocks trade on the New York Stock Exchange, the American Stock Exchange or the NASDAQ. Your chances of running into fraud are lessened – not completely excluded, of course, but definitely lessened. Exchange-traded stocks are required to report financial conditions accurately and regularly. It doesn’t always take place, but we’re putting together a series of filters that increase your odds of winning. No guarantees, just the likelihood of better probabilities.
What to Skip.
The heavily-regulated industries don’t quite fit here. And by heavily-regulated I am talking about government-regulated. Utilities and banks, for example: it’s a different world and though some of them may be considered by some to be value stocks, it requires a separate kind of analysis than we’re doing here. Similar in many ways, but when it comes to analyzing debt, both current and long-term, what’s appropriate in most industries no longer applies. My solution is this: I skip them. Makes it easy. I find enough interesting situations without them.
Filtering Out What Doesn’t Fit.
To identify value stocks, you’ll need to filter out what doesn’t fit. That’s the main thing. This is accomplished with the use of the financial metrics and measures that we’ve stated: the price/earnings ratio, the book value, the current ratio and the debt/equity ratio. If the stock is still a fit after checking that list, the final cut is: does it pay a dividend? If it does, what remains on the list are those potential candidates for serious consideration as what is classically known to analysts as “value.” These filters may list stocks you’ve never heard of – that’s good, less known can mean undiscovered.
I’m not an economist. Obviously. But I don’t think this value approach is enormously complicated or so filled with complexity that it’s impossible to understand. It’s the sort of thing I learned from my parents growing up: when shopping, find something of quality that you can purchase for less than you’d expect. Naturally, it might take a while and you’d have to have a decent awareness of where to shop and what to look for. The avocadoes are occasionally just right in terms of ripeness and just right in terms of price, but it’s not too often you get the combination of the two. A knowledgeable shopper knows when.
If you have the patience and discipline required and what you’re looking for is actual investment for the long term, then you might want to begin to analyze stocks for value – value in the classic sense as practiced by the original deep thinkers of market analysis. I don’t think it would take too long to get up to speed on learning the basics of this yourself – if you can add and subtract, divide and multiply, you’re about halfway there. Looking at information, looking for specific numbers, judging the meaning of what you find and developing reasonable conclusions – you don’t need an MBA from Wharton or a Goldman Sachs desk to do this.
You’ll need to stop watching the business media channels all day and stop reading the financial print media every morning, if you’re still doing that. Well, maybe you won’t be able to stop completely, but you’ll want to unhook as much as possible and stick to looking for the numbers you need and avoid the urge to find out what leading Wall Street spokespersons are propagating. That might be the tough part: skipping the exciting horse race-style coverage that direct you away from the material that really matters.
Value Stocks Are Tough to Find and Can Be Ugly.
In our era the notion that you should look for stocks trading below book value is mostly considered a waste of time. Why would you want to fool around with something that’s clearly so unproductive? For one thing, any stock found using that screen is probably priced that way because it’s widely thought to be nearing bankruptcy or involved in some nearly intractable financial situation or one of the last still going in a dying industry. This is why screening for all of the other metrics is so important. If the company is almost bankrupt, then checking the debt levels, especially the debt-to-equity, should keep you from looking further into it.
Same thing applies to whatever “nearly intractable situation but not bankrupt” – it’s will show in the debt measures, if there’s more debt than equity, that’s a stop sign not a yellow light. “Last company in a dying industry” is interesting, though, because if they have assets and whatever product they’re making is still selling, then it’s always possible that another company may be interested in buying it up. Might be a much larger company or it might be a much smaller company with the ability to borrow money to do it. From the investor standpoint, it doesn’t matter, all you need is “below book” and a satisfactory look from the other measures.
I remember finding a publicly traded cigar company on one of my first screens back in the early 1980’s. Every metric fit the value criteria: it paid a fat dividend, the p/e was low, they had a decent earnings record, debt seemed under control and the market price traded below book value. Aside from the obvious health concerns involved, cigar smoking already had this “from the 1950s” quality. If you were okay with smoking and could see another tobacco company eventually buying it up for the assets, it might make sense. I was okay with cigars at the time, but now I’m not. Once you’ve identified some value situations, you may experience a sense of revulsion at their product or industry.
Even with the screening for metrics – including the look at book value – the value stock investor has to consider the whole picture. Once you’ve got the list, studying the background and context for each stock is necessary. Are the reasons for this stock to be undervalued — compared to other stocks — sufficient to go ahead and make the investment? The answer is usually but it depends. Will you be comfortable knowing that it might be the last money-making business in a slowly decaying industry? That may require more insight than just the cold numbers and becomes a “does this make sense for me” question that only you can answer. But based on the screens for value using these metrics you probably have some good choices.
Holding on to Value.
If your decision is to concentrate only on value stocks, it’s probably best to avoid the minute-by-minute media reports about the stock market. It’s not necessary to keep up with the constant play-by-play once you’ve invested with long-term goals in mind. Not that it’s always relaxing – big events play out occasionally – but nerve-racking, sleepless nights or nail biting weekends tend to be greatly diminished if you’re doing it right. I wouldn’t necessarily be skipping the business section of the paper every single day, but you may find that, generally, a scan on Saturday mornings of your value stock portfolio probably covers it.
What I’ve covered here are the basics of value stock investing. It’s what I’ve learned about it by reading and studying the materials since I first heard about it on Wall Street Week back in the 70s. I have no doubt that many other methods exist for finding the best based on other valid, perhaps better, measures of value. You could probably find and read materials about the subject for many more years and develop several more advanced types of approaches. I’m not pretending to have covered everything.
Also, at the time of this writing, the business cycle is such that few value stocks as described here are even available. But that won’t last forever.
Metrics courtesy of FinViz.com.
No specific recommendations are made one way or the other. If you’re an investor, you’d want to look much deeper into each of these types of situations. You can lose money trading or investing in stocks. Always do your own independent research, due diligence and seek professional advice from a licensed investment advisor.