I’ve warmed you up during the last two sessions, so again it’s time to dive a little deeper! This go-around, I want to focus on some of the useful tools and things to look for when selecting beat-up, kicked-to-the-curb, unloved, value oriented stocks – yep, those with big upside potential. So bust out your green shaded visor and get your calculator ready, because this, my friend, is where the rubber meets the road.
RULE #1: Stocks are driven by earnings – P/E Ratio
If there’s one thing you take away from this post, please remember that YOU MUST PAY ATTENTION TO EARNINGS! Without earnings, a company has absolutely no business being a business. I like to look for a history of solidly growing earnings (e.g. net income or earnings per share) or at minimum a clear sign of historical earnings stability. Since we’re dealing with value stocks here, chances are high that the last year or two have probably been tough, and earnings may have taken a dive. Remember though, we’re looking for “normalized” earnings potential, so as long as the business model is sound, do not be frightened by weak current earnings.
The investment community has a short-term horizon, and weak current or near-term earnings generally will be reflected in the currently cheap stock price. The key ratio to think about here is Price-to-Earnings.
I like to visit a free website at www.finviz.com and click on their screener tab. I then screen for Forward P/E ratios < 10. Why 10 times earnings? Well for starters, it’s important to understand that the inverse of the P/E ratio is called the earnings yield. This ratio tells you the yield you’d theoretically receive if a company paid out all of it’s earnings to you in cash. Taking the inverse of 10, would get you a 10% earnings yield on today’s stock price – a nice return compared to the current 10yr. Treasury rate of 2.6%! I also look at “forward” P/E because this incorporates the current consensus view of the coming year’s earnings relative to today’s stock price.
Aside: Just for the record, there are some pretty sweet industry leading companies that immediately jump off the screen for Forward P/E <10: Ford, GM, IBM, HP just to name a few at the time of this writing.
I also like to compare the P/E ratio to a list of peers’ P/E ratios to make sure the company I’m looking at is extra attractive. It wouldn’t hurt to also compare the current P/E with the company’s own historical P/E ratios (although this is tougher to do without the right software or financial modeling subscriptions). The idea is to buy a company when its P/E is below peer average and below its own historical average. Generally speaking, this confirms the market’s uncertainty and gives you the greatest opportunity!
A word on low P/E stocks vs. high P/E stocks: High P/E stocks (think Netflix, Tesla, Twitter, or other “glamour” stocks) have a ton of built up expectations. Time after time, an investor in a high P/E stock is setting himself up for disappointment. High P/E stocks must continue to outperform and shine, which is obviously hard to do. Low P/E stocks, on the other hand, don’t have a lot riding on their success. Bad news is generally already reflected in the stock price, so any good news or outperformance should result in a nice stock price pop upwards!
RULE #2: Buy stocks as low as possible relative to net worth – P/B Ratio
The operative ratio here is the Price-to-Book ratio or P/B for short. The ratio compares the current stock price of the company to its book value per share. Book value refers to the total equity of the company, or assets minus liabilities. In an ideal world, I’d tell you to always buy companies trading below 1 times their book value (Benjamin Graham made quite a fortune buying stocks for pennies on their book value!). In today’s world, these situations are harder to come by – at least for companies worth buying. To buy a company below 1 times book value, you may need to scrape the bottom of the barrel if you are so willing.
If you want a quality company, opportunities may only come around once in a life time (like the financial crises) to buy below book value.
For our purposes here, just concentrate on buying below peer average P/B ratios and a low P/B ratios relative to the company’s history.
RULE #3: Buy a lot of economic activity on the cheap – P/S ratio
Here we’re comparing a stock’s price to its annualized total revenue or sales per share. The Price-to-Sales ratio allows us to make sure we are buying big time financial or economic activity for as cheap a price as possible. Again, compared to peers as well as the company’s own historical P/S ratio, is the stock cheap?
Not to get too granular on you here, but through the math derived from DuPont Analysis, a company can generate meaningful Return on Equity, either by having a low P/S ratio, or by having a high net income margin (net income-to-sales). Buying a company at a low P/S ratio means margins don’t have to be as high to generate a satisfactory ROE, all things being equal.
RULE #4: Buy great balance sheets – Low debt!
Yet another screen criteria you can put in the handy www.finviz.com screener, the Debt-to-Equity ratio provides a quick measure of how the firm finances its assets. Does it own them virtually free and clear as indicated by a low D/E ratio, or has it financed most all its assets with debt as indicated by a very high D/E ratio. Typically, I like to consider business with debt at less than 50% of equity.
A quick word on leverage as it pertains to DuPont Analysis. As the formula goes, a company can drive return on equity by any or all of three things – leverage use, margins, and/or efficient use of assets. Sure, many companies utilized debt to leverage their returns on equity, but I’d rather see great returns generated by the next two factors – strong margins and/or strong use of the company’s asset base to generate sales.
Superior execution should drive return on equity not simple financial engineering through the use of debt.
RULE #5: Buy franchise businesses
“An economic franchise arises from a product or service that (1) is needed or desired; (2) is thought by its competitors to have no close substitute and; (3) is not subject to price regulation. The existence of all three conditions will be demonstrated by a company’s ability to regularly price its products or service aggressively and thereby to earn high rates of return on capital.” – Warren Buffett, Shareholder Letter, Berkshire Hathaway, Inc. Annual Report, 1991
I think of a franchise as a business having a sustainable competitive advantage of some sort. To put it another way, a franchise business model would be extremely difficult for a new competitor to emulate or improve upon. Because of this, the business should be able to generate higher than average returns on its capital base because of its ability to attract customers to its higher than average product pricing. The company is able to keep prices higher than prices of the competition, because the perceived value of the company’s products are higher, thus making them more desirable.
I think Apple (AAPL) is a perfect example of this. Apple was the first to introduce its tablet, the iPad, which has augured much success for obvious reasons, it’s sleek, pretty, reliable, simple, handy and extremely useful. Sure, competing products have come out from its technology peers, including many at lower price points. Yet, the iPad is still the benchmark product. It’s still the preferred item. So, its price can be maintained higher.
So how to we quantitatively determine whether or not a business is a franchise? Just like mentioned above, we look for businesses that can generate sustainability high and/or growing Return on Equity with little use of leverage. Again, this indicates that company management is executing well with the great products it has.
RULE #6: Follow the smart money
No one knows or understands a company better than senior level management or its board of directors. A great indication that a company is undervalued is a buy initiated by one of these “insiders” for their personal portfolio. History has shown that stocks purchased by insiders have greatly outperformed the rest of the stock market.
Curious if there’s been insider buying of a company in which you have interest? Again, visit www.finviz.com (what a great site!), type your ticker in the search bar, and then scroll down to the bottom of the page to see a recent list. If an insider is buying, there’s yet another reason to consider the stock for your personal portfolio!
A company buying back its own shares is another strong signal of undervaluation. The lower the stock price compared to the book value per share, the more beneficial a company’s buyback program becomes. When a company buys back its own shares, the total shares outstanding (publicly traded) diminishes, so your relative ownership increases. Thus, you’re share of the company’s cash flow, earnings, and book value just went up without you having to do anything!
RULE #7: When in doubt, trust mean reversion.
Bad things always happen to good companies. But rest assured, the bad situation will usually reverse itself at some point. Severely undervalued names (on P/E, P/B, P/S basis) tend to trade back to historical averages after a long enough time period as they work their issues out.
As long as your portfolio is adequately diversified (I’d say 15-20 stocks is plenty), this kind of mean reversion will be happening all over the place in different stocks. Hopefully you’ve taken my advice and purchased a stock below its average valuation range or the range of its peer group, so you’re upside will be reflected both in mean reversion AND improvement in earnings! This double-whammy effect is what truly drives superior long term outperformance for value investors!
So there you have it…my rules for value investing. I’d love to hear you’re thoughts and questions!
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