Any stock on your watchlist has the potential to become undervalued, and thus a more attractive investment, if the broader market fails to reflect the underlying company’s true worth.
This dislocation can manifest itself in a variety of ways, all of which share an excessively pessimistic view about a company’s future, despite otherwise strong fundamentals, opening the door for optimistic allocators to recognize a bargain in the market’s dreary outlook.
In the interest of brushing up on our bargain-hunting skills, let’s consider five of the top strategies investors can apply to identify value stocks, as selected by Google Gemini based on search results from Canadian investors over the past month:
- Low valuation ratios.
- Margin of safety.
- Financial quality and health.
- Moat or sustainable competitive advantage.
- A major catalyst on the horizon.
5 essential investment strategies for vetting value stocks
1. Low valuation ratios
We begin our survey of strategies to identify value stock with the concept of a valuation ratio, which is nothing more than a company’s stock price divided by a strategically chosen financial metric. The idea here is that companies in similar industries can be evaluated based on these ratios, highlighting their relative value against each other, the industry’s historical averages or the market at large.
One of the most common metrics is the price-to-earnings (P/E) ratio, resulting from the stock price divided by yearly net income, granting investors a sense of what they’re paying for each dollar of a company’s earnings. You can find average P/E ratios for industries in the US market through Aswath Damodaran, the well-known finance and valuation professor at the Stern School of Business at New York University.
Another popular metric, the price-to-book ratio (P/B), measures a company’s stock price against the net value of its assets, allowing you to gauge whether or not a company is trading for more or less than what it would earn through a total liquidation. If the ratio is less than 1, your target company is trading for less than what its assets are worth.
Other useful ratios include price-to-free-cash-flow, highlighting a company’s ability to generate cash after working capital and expenditures, price-to-EBITDA, which is mostly reserved for companies in high-growth mode that have yet to turn cash flow positive, and price-to-net-debt, a measure of leverage we’ll look into further in step 3 covering financial quality and health.
To get your due diligence started on the right foot, take a look at Ready Ratios’ average financial ratios across the US industrial landscape, equipping your expectations with a reasonable baseline as you work your way down your watchlist.
2. Margin of safety
Another strategy to home in on value stocks, created by Benjamin Graham, the father of value investing, involves the calculation of a company’s intrinsic value, usually expressed as an estimated share price, enabling investors to buy at a discount should the circumstances arise.
To calculate intrinsic value, investors tend to resort to building a discounted cash flow model, projecting a company’s cash flows into the future and adjusting them back to their present-day value. Success will largely depend on correctly estimating these cash flows, requiring you to assess products and services, target market, competitors and potential risks to come up with reasonable figures that are conservative enough to ensure your bargain investment is actually a bargain.
The larger the margin of safety, the greater the buffer your investment will have against unforeseen volatility, increasing your chances of a satisfactory long-term return.
3. Financial quality and health
Assessing a company’s financial health is also a reliable means of pinpointing undervaluation, pairing high-quality operations with a share price falling for exogenous reasons unlikely to impact long-term growth and profitability. Pillars of a strong business model include:
- A low price-to-net-debt ratio, which is evidence of an opportunity to buy the company’s net cash for a low price. Readers can also consult the current ratio, or current assets divided by current liabilities, with a higher number indicating an enhanced ability to cover debt due over the next 12 months.
- Growing revenue and earnings power, the latter in the form of net income or EBITDA, ideally over multiple years, demonstrating leadership’s ability to foster shareholder value despite the ever-changing nature of economic conditions.
- A leadership team that has been there and done that, keen on replicating past successes in the same industry as your target value stock.
- A target market that adds value to people’s lives in one way or another, affording you enough conviction in its ability to thrive over the long-term and serve as the foundation for your prospective company’s value creation.
Make sure these pillars are in place and you’ll have gone a long way to protecting yourself from falling into a value trap, or a business that appears to be trading at a discount, but is in fact deserving of its low stock price because of underlying problems – including stalled innovation, poor leadership or a low-growth industry – that only deep due diligence can reveal.
4. Moat or sustainable competitive advantage
Penultimate in our overview of value stocks’ key traits is the concept of a moat, or sustainable competitive advantage, made famous by 94-year-old Warren Buffett, Ben Graham’s most notable disciple. Buffett recently announced that he’s stepping down as chief executive office of Berkshire Hathaway (NYSE:BRK.A), his trillion-dollar investment holding company, after more than 60 years in the role spent studying and investing in companies with enduring moats.
What we’re talking about here is a structural feature of the business that insulates it from competitors and slow economic environments, reinforcing its prospects for value creation. Think the brand power of Apple and Coca-Cola, the cost advantages of Costco and Wal-Mart, or Visa’s entrenched global network, which have proven to keep customers coming back and cash flowing in year after year after decades of building up cachet in the marketplace.
Should you stumble upon a public company donning this kind of armor, without much in the way of share price recognition, you may have a value stock on your hands, meriting a thorough fundamental analysis to verify what the market is missing.
5. A major catalyst on the horizon
We end our look into value stocks and how to spot them with a few words on short-term thinking, a common fault among investors new and seasoned, where a company’s grander goals take a backseat to minor operational issues obfuscating the potential for a significant re-valuation.
Is a company with a differentiated product really on its last legs, or is the broader industry simply in a generalized slump that will work itself out over time as the product is diligently advanced into the market?
Does a management change really call for unfettered panic and immediately hitting the sell button, or will fresh eyes reinvigorate operations over the coming years?
Should capital-intensive capacity expansion, including a burgeoning debt load, be met with skepticism, or should a contrarian’s taste for turmoil kick in, prompting a bargain investment positioned to pay off after a few patient years?
An investor’s perspective should ideally be one of no pain, no gain, keeping front-and-centre the fact that long-term shareholder value often calls for rising out of unprofitability, as opposed to starting operations in the black, because the innovation that leads to brand loyalty, like any great idea, often involves years of diligent trial and error.
If insiders are buying the stock on the open market when times are tough, all the better, as their willingness to sit on losses alongside you, having full operational knowledge of the company, paints a rosy picture of the future.
Tying it all together
While the efficient market hypothesis is a beautiful theory, refined by the symmetry of stock prices reflecting publicly available information at all times, any seasoned investor will know that, while this is true over longer periods, short-term dislocations are common occurences.
But to make theses dislocations useful, you must know how to assess a business’ ability to deliver on its promises, and whether or not the promises are worth making in the first place, keeping the highest standards for stocks to merit your hard-earned dollars.
So the next time your stock screener turns up a potentially underpriced name, make sure to put it through the wringer, from front office to back office, to maximize the mileage of the money you put to work.
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