7 Value Investing Strategies to Find the Market’s Best Bargains

value investing - 7 Value Investing Strategies to Find the Market’s Best Bargains

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For years now, this has been a market for growth investing, not value investing. Stocks that look expensive only seem to get more expensive. Supposed value stocks look cheap, and quite often stay that way.

The pendulum should shift at some point. While the long-awaited rotation from growth to value has been forecast for a decade now, it will arrive eventually. In the meantime, value investing still can be rewarding — if done correctly.

Admittedly, that’s easier said than done. There’s no one-size-fits-all way to find quality value stocks. Attractive fundamentals usually help, but big value winners can have attributes that don’t show up in near-term numbers. And stocks that look extraordinarily cheap can fail to deliver on their promise.

The right approach can go a long way, however. These seven strategies can be a big part of attacking value investing the right way:

  • Understanding Due Diligence
  • Value Investing Using Earnings and Cash Flow
  • Value Investing Using Assets
  • Looking for “Value Traps”
  • Going Beyond the Fundamentals
  • Reading the Filings
  • Paying Attention to Management and Catalysts

Value Investing: Understanding Due Diligence

Due diligence of course is important for all investing styles. But its importance is heightened in value investing, where the focus on fundamental analysis is greater. In growth investing, an investor can be successful using mostly qualitative analysis.

For instance, an investor who recognized the potential of Zoom Video Communications (NASDAQ:ZM) to benefit from the novel coronavirus pandemic did not have to pay exactly the right price. The same is true of other big winners like Shopify (NYSE:SHOP) or Tesla (NASDAQ:TSLA). A growth winner can take care of valuation concerns in a hurry, assuming of course that the growth story plays out. If the story doesn’t play out, generally speaking, paying a lower price won’t be enough to salvage positive returns.

But value investing is based on the goal of paying the correct price based on current value. And most (but not all) value targets generally aren’t growing nearly as fast. On occasion, a business may actually be in decline, but a “cigar butt” bull case means there’s enough value anyway.

From a fundamental perspective, there’s simply less room for error. And that means due diligence needs to be, well, diligent.

Due diligence covers all aspects of a stock, each of which has its own challenges and opportunities. But from the outset, investors need to understand that value investing is not and cannot be simple.

Value investing is not just buying stocks with low price-earnings multiples or high dividend yields. Importantly, it doesn’t rest solely on using publicly available figures which may have errors or, more commonly, don’t account for one-time factors that may inflate or deflate earnings or asset value.

In a word, value investing is complicated. That’s why it is challenging, and why it can be rewarding.

Using Earnings and Cash Flow

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Even though value investing isn’t just about low price-earnings or price-free cash flow multiples, those characteristics can be a big part of a value-based bull case. If the multiple is too low relative to growth, the stock should be a buy.

Again, figuring out whether the multiple is too low is easier said than done. And growth investors too can believe that a stock price doesn’t reflect the potential of the business. At the end of the day, all investing is value investing.

But what value investors look for is a stock that, simply put, is too cheap relative to its ability to generate earnings or cash flow. It’s worth noting that those two metrics are not the same thing. Earnings are based on accounting practices that generally smooth the result, for instance by deducting depreciation, which is calculated on an annualized basis over the life of the asset.

Free cash flow, however, is based on the actual cash that comes in the door, which can see significant volatility. Capital expenditures — cash spent to acquire or build assets which are then depreciated — can vary widely from year to year. Changes in working capital like inventory too can impact free cash flow in a given period.

Earnings generally offer a smoother, more normalized picture of how profitable a business usually is. But not always. Non-cash figures like depreciation and amortization can reduce earnings in a way that obscures strong, consistent, free cash flow generation.

Of course, using either earnings or free cash flow, one difficulty in value investing is determining whether a stock indeed is too cheap. A discounted cash flow model, which uses growth estimates and a discount rate that reflects expected return, is one tool. But DCF models are only as good as the inputs. If an investor believes growth will be faster, or longer, than proves to be the case, a DCF result will turn out to be too high.

Rules of thumb also help. Using an 8% discount rate (the expected return), a stock with zero earnings growth in theory should trade at 12.5x earnings. A mid-teen price-earnings multiple, then, prices in quite modest growth. If an investor sees a stock trading at 16x or 18x earnings, but sees impressive growth on the way, she may well have found a winner.

Value Investing: Using Assets

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Value investors do not just look at earnings. Assets can underpin a bull case as well.

After all, it is possible for a stock price to fall below the actual value of the company’s assets. A well-covered recent example is Dell (NYSE:DELL), whose stake in VMware (NYSE:VMW) is worth more than the company’s entire market capitalization. Even considering debt on the balance sheet, it was and still is relatively simple to create a sum of the parts case that Dell’s assets were being undervalued by the market.

Hard assets like real estate, as opposed to ownership of equity stakes or entire businesses, can underpin an asset-based bull case. So can cash on the balance sheet. On occasion, stocks can actually trade below their hypothetical liquidation value. In other words, if management shut down the business tomorrow, sold inventory and property at fire-sale prices, and returned the cash shareholders, those shareholders still would turn a profit. In theory, though not always in practice, liquidation value should present something close to a floor for the stock price, creating what colloquially is called a “heads I win, tails I don’t lose much” scenario.

There is one major catch with asset-based bull cases: They usually suggest significant problems with the business itself. After all, if the assets have real value, but the business is turning a minimal profit (or posting losses), then the company is doing an exceedingly poor job of utilizing those assets.

An excellent example of this problem is restaurant operator Ruby Tuesday. For years, value investors argued that Ruby Tuesday stock was too cheap as it traded well below the market value of its owned restaurant portfolio. Yet Ruby Tuesday, operating in those owned properties, was not making any money.

Thus, the value case argued that the properties would be far more valuable if they had another restaurant in them. Unsurprisingly, that case never gained much traction with the market.

Ruby Tuesday wound up going private in 2017 for well less than $3 per share. Long-term shareholders who bet on the real estate-driven value case generally lost a good chunk of their original investment. Assets alone generally are not enough for a solid bull case.

Looking for ‘Value Traps’

Whatever the fundamental metric used to find a value play, it’s important to remember that numbers alone don’t make a bull case. Value investing is not just about finding “cheap” stocks. It’s about finding undervalued stocks.

After all, many stocks are cheap by at least some fundamental direction. Many are cheap for good reason — because the market expects earnings growth to slow or, in some cases, fears that it will turn negative.

So if the fundamentals are attractive — particularly in a market still just off all-time highs — the default assumption should be that the market is adjusting the valuation to fit the company’s outlook, rather than leaving a buying opportunity laying in plain sight. That’s particularly true for well-covered large-cap names.

One obvious example is AT&T (NYSE:T). T stock looks dirt cheap at 9x forward earnings and 1.15x book value. The AT&T dividend yields 7.4% at a time when the 10-year Treasury offers less than 1%. On its face, T stock looks like one of the biggest bargains in the market.

But AT&T stock is one of the market’s widely owned stocks. There should be reasons why the stock is cheap — and there are. DirecTV is in decline, and its attempt to sell the business reportedly has led to only “lowball” bids. The wireline business is fading away. It also continues to struggle against rivals Verizon Communications (NYSE:VZ) and T-Mobile (NASDAQ:TMUS). Time Warner faces cord-cutting pressure.

There are very real risks here that suggest that T stock should be cheap right now.

To be clear, that doesn’t mean there’s no bull case for T stock. Indeed, the company posted solid third-quarter results that showed strength in key areas, including wireless subscriber adds. But an investor making that bull case can’t just look at the numbers, and particularly the simple, headline numbers like dividend yield and P/E multiple. That investor must believe, with good reason, that the market is underestimating AT&T’s growth potential.

Simple numbers aren’t enough to make that case. For AT&T stock, it hasn’t been enough. Investors could and did make a simple case based on valuation in recent years. Over the past five years, even with that yield, T stock has returned 9% total. The S&P 500, including dividends, has returned 86%.

Value Investing: Going Beyond the Fundamentals

All told, a value case has to go beyond the numbers. But a good case doesn’t have to rely on the numbers at all.

The most common type of value case that goes beyond the fundamentals is a turnaround play. Two widely owned such plays right now are General Electric (NYSE:GE) and Rite Aid (NYSE:RAD). GE stock trades at 23x forward earnings and 2x book value; neither multiple looks attractive. Rite Aid is likely to be unprofitable this fiscal year, based on its guidance. RAD stock does trade below book value, but due solely to intangible assets and goodwill.

The hope for both companies, and many others, is that operations will improve, and the fundamentals will follow. In other words, those stocks aren’t cheap yet, but they could be in the future.

Again, value investing is not just about looking at the numbers. Sometimes, the numbers deceive. A long-time value favorite is the St. Joe Company (NYSE:JOE), a real estate developer in Florida. JOE stock trades at almost 50x trailing 12-month earnings and nearly 3x book value. But bulls argue that is largely because neither profit nor balance sheet accounting properly captures the value the company is creating.

Those bulls have had to wait a long time, as JOE spent a decade trading mostly sideways. The stock finally has broken out this year to an eight-year high.

Reading the Filings

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Obviously, examining all these aspects of multiple stocks is not easy. But it bears repeating: Value investing is not simple.

And there is a way for an investor to gather this information: company filings with the U.S. Securities and Exchange Commission. SEC filings are not necessarily a shortcut, but they contain a vast amount of information. Legal requirements, meanwhile, ensure that the information in the filings is trustworthy. Chief executive officers and chief financial officers must certify annual and quarterly filings as accurate.

Annual filings on Form 10-K in particular contain both a wealth of data and commentary. The company’s financial metrics are disclosed not just for the most recent year, but past periods as well. Recent regulations require many companies to provide “disaggregation of revenue,” which breaks down the categories of revenue generated by the business.

The “Risk Factors” section ranges from broad (terror attacks) to company-specific challenges related to competition or execution. And the “Management Discussion and Analysis,” often referred to as the MD&A, gives often-detailed explanation for the company’s performance.

For many investors beginning their due diligence, Form 10-K is the starting point. And even for stocks and companies that investors know well, these forms can provide new and valuable insights.

Value Investing: Paying Attention to Management and Catalysts

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One of the more difficult aspects of value investing is dealing with management. Quite often, management is, if not the actual case of a stock being cheap, a roadblock to a rally.

For cash-rich stocks, for instance, the worry is that management will squander the cash on an acquisition instead of returning it to shareholders or making wise investments in the business. In other cases, there may be a path to unlocking shareholder value in theory, but a management team that remains stubborn. (One common issue: A company that should sell itself, only for entrenched managers to prefer job security to shareholder returns.)

There is also the catalyst problem. A stock that is cheap surely can stay cheap for quite a while. Particularly for larger, widely covered names, the story likely has to change before valuation on its own can drive a rally. This seems to be an issue right now for both Intel (NASDAQ:INTC) and International Business Machines (NYSE:IBM). Both stocks look cheap. But both companies are being treated by the markets as having passed their growth peaks. Until that perception changes, valuation likely won’t.

Of course, management can be a plus as well. New leadership often is a key part of a turnaround bull case. And savvy value investors can find a catalyst that the market is missing, whether it is a business unit that could (or will) be sold or an activist investor that will shake up operations.

It bears repeating: Value investing isn’t just about the numbers. That’s true in avoiding value traps, and it’s true in finding value plays as well.

On the date of publication, Vince Martin did not have (either directly or indirectly) any positions in the securities mentioned in this article. 

After spending time at a retail brokerage, Vince Martin has covered the financial industry for close to a decade for InvestorPlace.com and other outlets.  

Article printed from InvestorPlace Media, https://investorplace.com/7-value-investing-strategies-to-find-the-markets-best-bargains/.

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