How to spot a Value Stock

I’m using my discount broker’s stock screener to find some mid cap value stocks for an upcoming interview. I’m inputting criteria like high pay out ratio, high dividend yield, and low debt to equity. It is working ok, but I’m not certain this is the right way to go about it. I know some people here are die hard value gurus, can you offer some suggestions for which inputs I should focus on for a mote (high barriers to entry, high pricing power) mid cap value stock?

And yes, I do feel kinda retarded asking this. My ER experience is null.

The true value investors I know tend to focus on Price/Book more than Price/Earnings, however it is possible to screen for high P/E. I’m not a big value person, although I respect the methodology and the theory behind it. Generally you will want to compare price multiples to the average multiple of the industry the company is in. You might also compare price multiples to the company’s own historic multiples and see if the company is on the high side or the low side. Also P/E ratios have a “justifiable” ratio (at least for mature, dividend paying companies) that you can use to compare current P/E to. Once you have that data, go ahead and rank them by percentiles, deciles, quartiles, or whatever. Choose the lowest quartiles and select them for additional analysis to avoid the “value trap” (the value trap is when the price is low for a good reason, like fraud, bad management, overstated B/S assets, low future prospects, etc.). There are other ways to do it, but those are the ones that jump out at me for screening purposes. There are other value investors on this board, and I’d be really interested in seeing what they suggest.

(Some Google Research) Value Stocks Value stocks are not cheap stocks, although one of the places you can look for candidates is on the list of stocks that have hit 52-week lows. Investors like to think of value stocks as bargains. The market has under valued the stock for a variety of reasons and the investor hopes to get in before the market corrects the price. Here are some characteristics of a value stock * The price earnings ratio (P/E) should be in the bottom 10% of all companies. * A price to earning growth ration (PEG) should be less than 1, which indicates the company is undervalued. * There should be at least as much equity as debt. * Current assets at twice current liabilities. * Share price at tangible book value or less. Some investors use more criteria, but these will get you started in identifying value stocks.

oops, I said screen for high P/E, when I really meant screen for low P/E. (You can screen for high P/E, P/B or whatever, as a source for shorting options under the value methodology). A lot of value investing is about trying to estimate company value as conservatively as possible (tangible book value + the perpetuity value of current business earnings + PV of growth beyond current earnings), and then seeing if the price is below even those values. The distance between current price and your estimate of current value (assuming the price is below that value) is called the “margin of safety,” which basically lets you know how much you can afford to have forgotten about before you make a bad investment.

Curious Bchadwick, what type of investments do you look for?

I’m a macro investor, so commodities, currencies, equity indicies. I’m learning more about how to do interest rate and yield curve strategies. When I do equities, I actually think more in terms of growth stocks. It’s not that value doesn’t seem to outperform growth (usually), but Damodaran reports that growth managers outperform their benchmarks more often than value managers do. Actually, good growth analysis isn’t so different from good value analysis - you’re still looking for underpriced stocks - just “underpriced relative to the expected growth.”

Thanks. I would like to do more macro style investing but the level of capital I have doesn’t permit me to take on those kinds of positions. Macro is more interesting to me and probably fits my knowledge level better than equities investing.

If macro fits how you think and you enjoy it I say do it. If you try to fit yourself into something you don’t enjoy you’re never going to dig deep enough or gain the knowledge required to really grow into it. Value investing takes time and learning, if you don’t enjoy the learning you won’t develop into a good value investor. I don’t know how much money you have but it seems you could do most of the macro stuff with about 10k at Interactive Brokers. Honestly without 10k I’m not sure how the value stuff will work either, with 10k you could have 10 positions of 1k each. I’d suggest starting out dumping most of your money into a good value fund, and doing tons of research, as you have convictions establish a position or two outside of your fund with new money. Grow your portfolio this way it’ll encourage you to save as well. At a small capital level savings is going to mean much more than investment gains.

10K? Isn’t it really hard to put a position on, especially in the commodities sector with that amount? I have about 5K that I invest in now, but it is just equities, no special situations or anything. I should have the 10k saved in about 4 months, investment returns have been pretty good so far starting with 3K but I am relatively new so I have caught this rally by luck rather than skill. Who knows where that 3k would be if I had started in 2004. Thanks for the advice though.

At Interactive Brokers commissions are pretty cheap, and you can do futures and options for commodities and currencies all with small amounts of capital.

Start with Berkshire annual reports. Read Graham’s Intelligent Investor.

although most texts warn against it, i think its wrong to screen out companies with high debt to equity ratios. i think screening out debt-laden companies lessens the amount of work you’ll have to do, but i have seen plenty of occurences where debt-laden companies trade below their liquidation value. when this happens with resource companies, the calculated value is even more identifiable and reliable. i also think a CA/CL screen will eliminate some of the best value candidates. also, performing these screens (and including the filters discussed about) at this point in the cycle, you will miss many undervalued companies as they are currently undergoing debt reduction and/or restructuring and their CA and expected debt levels will be different from current levels.

Remember that Buffett does not see a distinction between growth and value. I think that is one of the golden rules of investing. I would screen for high roe over the last five years. Low reported debt to equity. Fairly consistent top-line and bottom-line growth over the past 10 years. Low net debt relative to market cap/net income or even net cash. High FCFF yield (ideally due to sustainably low capex). High % of treasury stock in equity (indicitive of buybacks) and/or high div yield. To the best of my understanding, those are the things that Buffett looks for in a company to indicate that it has a sustainable competitive advantage or ‘moat’. If you find a company with the above characteristics, almost certainly it will have seen very rapid share price growth. The tricky part is finding the ten-baggers of the future. See Philip Fisher’s 15 points as a starting point for that analysis. I think MattlikesAnalysis’s suggestion of looking at companies with poor balance sheets that are trading below liquidation value is sound. They are the classic Graham ‘cigar butts’. You may well double your money on a company like that (of course, you could easily lose money too), but if you are after a really great investment that will earn you a 1000% return, you need to screen for the really top copmpanies as much as you can.

All of these are great suggestions. There are so many different ways to skin the proverbial cat when selecting “value” stocks. As Carson pointed out, there really insn’t a single characteristic that defines a stock as a “value” stock. As Charlie Munger stated, “all intelligent investing is value investing.” The low P/B, P/CF, P/E method has been proven empirically - so those are variables that you can use to screen for attractive investments. It also depends what type of situation you are looking to identify: Cigar Butt (net-net) Merger Arb Special Situations GARP (more akin to Buffett today) I personally find that being a reading machine helps you sharpen your skills. It was Lynch that stated that the person who turns over the most rocks wins. I scour Value Line and just do back of the envelope math to identify companies that deserve a closer examination. 52-week low lists are certainly great hunting grounds. 13Fs, Value Investor Insight, periodic Manager Letters, etc. The resources are unlimited. Its best to keep your approach flexible since the type of opportunities and the depth of those opportunities is continually changing. So I guess what I am trying to say is that it all depends. That’s my 2 cents.

Agreed. No single answer to this sort of work. Looking at 52-week low lists is a good shout. You can incorporate that into a screen maybe by looking at stocks with 5-year average ROE and ROIC>15%, P/E<10x and say >30% below 12 month high and <10% above 12 month low. Something along those lines to indicate some inherent quality but also cheap and near recent lows. Then you try to sift through the rubble to weed out lawsuits and big earnings downgrades etc that might have pulled the stock down.

depending on where the market is at, using screens may be useful. I agree with the filters used as they’re definitely good signs. however, most, or almost no real true bargains show up using these screens for the simple reason that everybody uses it. I know some of you will disagree and point to such and such selling at net net. But of almost all the net nets i have found, they were almost always speculative issues. if everybody here knows it, how you expect the pros not to have used it? I used the respective filters throughout the year and there were a few gems here and there and definitely less as the year progressed. By and large, using screens to find bargains is a short cut. That’s not to say if you invested in all the all companies that came up you won’t outperform. that to me would be an interesting experiment.

I add market capitalization into my screens. I figure you’re not going to find something the market missed in the large- and mid-cap screens. Its in the small- and micro-cap companies that inefficiencies lurk. Those companies are also often easier to understand (and when you work 50+ hrs a week, study for the CFA, and try to have something resembling a life, its difficult to be a full time equity analyst as well). FrankArabia is right – if everyone is using those screens, where is your edge? That’s why I look in the microcap space – I hunt where only individual investors can tread (for liquidity reasons no institutional investor would invest in something so illiquid), and try to find value where no one else is looking.

I find that a lot of ppl use rules of thumbs as a substitute for thought. they might say…“just use net net, and invest”. it doens’t work that way unless you’re the only one who can spot it. buffet/munger’s method is simple indeed, but it is hard to execute. using a screen is simple to do and simple to execute. your returns however might contradict my statement. The real undervalued securities are ones you can’t screen out. 40 years ago, yes you could get big nice returns by being a robot after learning a bit of securities analysis. But Buffet also ran into the same problem when everybody knew how to make easy money simply by looking at some screens. that’s one of the reasons I think he switched his style up. nowadays, you have to take graham as the starting point and move on with your own philosophy. graham, like the CFA, is just the beginning. If you do use graham however, you would problably be holding cash as most stocks don’t even fit his requirement. I dont’ think you can find 5 stocks that would, if i’m wrong, please let me know.

I agree with mossy about the size, I go index funds or value funds for large, midcap and foreign. I’m not going to suddenly discover that Coke is undervalued sooner than anyone on the street who is watching it all the time. I go microcap and small cap as well, I’m not afraid to wade into a stock that trades a few times a month and has a market cap of 10m. At the same time when looking for the cigar butts I think screens are fine, mostly because a lot of individual investors looking at them have no idea what to do with it. I can’t tell you how many net-net candidates I’ve looked at and ruled out after looking at the balance sheet and realizing part of the current assets are encumbered and the full value can’t be realized, then reading on message boards people posting about how it’s worth xx liquidation. It’s very apparent to me that a small minority of individual investors actually read the filings, and notes to the filings and actually know how to make sense and translate that into an investment decision. I hear a lot of “I researched this stock heavily” which I have come to believe means reading the website, listening to the conf call cheer leading and scanning the financial ratios.