Posted: March 20, 2014
Value investing: Simple strategies
It doesn't have to be dauntingThomas Alley
Buy low, sell high. This simple adage sums up the value investing philosophy. But in practice, value investing is far from simple. Done right, it involves in-depth investigation of a company’s business, industry and competitors; a valuation of its assets and cash flows; and complex quantitative analyses of its financial results and stock performance. For everyday investors, a true value approach can be daunting.
Yet there are some simple strategies available to those who wish to pursue the value approach that can help them identify stocks that pose particular promise.
Value investors look for stocks whose intrinsic value is greater than their current price. They seek companies that have fallen out of favor but still have good fundamentals. Value stocks are considered bargain-priced compared with book value, replacement value or liquidation value. Typically, value stocks are priced much lower than stocks of similar companies in the same industry. This lower price may reflect investor reaction to recent company problems, such as disappointing earnings, negative publicity or legal problems, all of which may raise doubts about the companies' long-term prospects. The value group may also include stocks of new companies that have yet to be recognized by investors.
Stocks that may be undervalued share two critical qualities: strong fundamentals and attractive valuation metrics.
Benjamin Graham, the father of value investing, advocated a disciplined approach for identifying stocks with value. Critical to this approach is a familiarity with the business of the company you are investing in. You should be knowledgeable about what the company sells, how it operates, what the competitive environment is like, who manages it, and what its threats, opportunities, strengths and weaknesses are.
A good place to start is with businesses or industries you know or are interested in. Knowing a company’s products, customers, competitors and operating environment is essential in identifying its intrinsic value, and the more familiar you are with it, the better. Does the company have some unique competitive edge? Does it dominate its market? Is it in a sector or industry poised for growth? These factors can be key to future growth.
Next, narrow down the field by screening for companies that have a history of strong and consistent financial performance. Look at short- and long-term trends in sales and earnings, as well as cash flow. Also consider the company’s debt levels and cash position. And if the stock pays dividends, look at yield and consistency.
Financial characteristics that value investors typically look for include:
- Strong balance sheets with little or no debt
- High coverage of fixed charges, debt service and dividend payments
- Strong or improving operating margins
- Consistent growth in sales and earnings per share
- High return on equity or return on assets relative to peers
A company’s financial statements and an analysis of its financial results can be found in its annual report, or its SEC filings, which are available through the SEC website.
A number of different valuation ratios attempt to gauge a stock’s “priciness” by looking at the stock price as a proportion of its earnings, sales or book value (equity). These metrics can be used to compare the valuation of different securities and help determine how expensive a stock may be in comparison with comparable issues. Typically, value stocks are priced much lower than stocks of similar companies in the same industry. So with each of the following metrics, look for low values in comparison to peers or industry averages.
The most widely used valuation metric is the price-to-earnings (P/E) ratio. It is calculated by dividing a company’s closing price by its historical or projected per-share earnings over a specified period. Note that P/E ratios will differ depending upon what earnings are used. Often, analysts use projected earnings to compute this ratio, since stocks are traded on future expectations rather than past results.
Similarly, the price-to-sales (P/S) ratio is calculated by dividing a company’s closing price by its historical or projected sales. The price-to-book (P/B) ratio represents the closing price divided by the company’s book value, or common equity, per share.
Thomas Alley is Senior Vice President - Wealth Management with the Global Wealth Management Division of Morgan Stanley in the Denver Tech Center. He can be reached at 303-925-9705 or firstname.lastname@example.org.