For those without the power of clairvoyance, investing is murky. It’s hard to tell if you’re buying or selling at the right time and emotions tend to get the best of us.
There’s good news, though. Value investing, a popular school of thought regarding how to find attractively priced stocks, can remove many of these prominent anxieties. It’s a maddeningly simple philosophy: scour Wall Street for great companies that should dominate their industries for years to come. Then, buy stock in those companies when they’re cheap, and wait it out.
Eventually, the market will price that stock correctly. That is, much higher.
But how does one find these market-beating value stocks? There’s no universal how-to manual, but if you use these five tips, you’ll be ahead of the rest of the pack:
Consider various price-earnings ratios. When you divide a stock’s price by its earnings per share, you get the famed price-earnings ratio. P/E is easily the most ubiquitous ratio on Wall Street, and value investors have a stubborn tendency to hunt for stocks with lower-than-average ratios.
[Read: Why Not All ETFs Are Created Equal.]
There’s just one thing: The earnings used to calculate the P/E are past earnings.
Investors, says Kevin Mahn, chief investment officer at Hennion & Walsh, “are not buying into past earnings but rather future, potential earnings of a company.” That’s why it’s important to consider future earnings. But don’t think that strategy is infallible, Mahn says, since future earnings are always estimated.
Ken Little, managing director of investments at Brandes Investment Partners, also thinks you should look at variations of the P/E. Why? If earnings are in a rut, the P/E can “look optically high as the current level of earnings and cash may be temporarily depressed.”
For cyclical stocks especially, Little notes, this means using “normalized” P/E ratios like the CAPE ratio, which uses the inflation-adjusted average of the previous 10 years of earnings.
Bottom line: A low P/E is a good sign, but look at variations, such as the forward P/E and CAPE ratio, to get a fuller picture.
Invest in companies with economic moats. Simply put, companies with economic moats enjoy competitive advantages letting them earn higher returns than competitors for “multiple economic cycles,” Little says.
In a free market, competition naturally arises “in an attempt to take market share and compete away excess profitability.” For average companies, there’s no stopping this influx of competition and its negative effect on earnings.
[See: The 10 Best European Stock ETFs on the Market.]
But, Little says, companies with durable economic moats follow different rules. They have “more of an ability to fend off such competition and continue to earn rates of return above their cost of capital.” Cost advantages, high switching costs, patents, and barriers to entry can all give companies moats.
Find companies with strong free cash flow. Earnings are important, but they can still be manipulated — legally — via accounting gimmicks to impress investors or minimize taxes. Cash, however, is either there or it isn’t. And it holds ultimate transactional power.
It’s not rocket science, says Michael S. Beall, executive vice president at Davenport Asset Management.
“Dry powder is a good thing,” he says. “Having the financial flexibility to capitalize on future opportunities will create value over the long term.”
Jim Wright, a Covestor portfolio manager and chief investment officer of Harvest Financial Partners in Paoli, Pennsylvania, agrees.
Cash, when coupled with a good management team, is great for shareholders. Management “can use the excess cash to pay and increase the company’s dividend, repurchase stock, make strategic acquisitions or pay down debt.”
Ratio-wise, Wright says his firm gets “very excited” when they see stocks trading for 10 times free cash flow.
Find stocks with a large margin of safety. “Margin of safety is a concept that addresses the downside risk of an investment,” says Michael van Biema, founder and managing principal of van Biema Value Partners.
Quality value stocks must have significantly higher upside than downside, or a large margin of safety.
Imagine, he says, you’re considering a company that only sells gold jewelry. Imagine you examine the inventory and determine its exact weight.
Now, say you could buy that company for less than half the value of its gold inventory. You’d have a killer margin of safety, since in a worst-case scenario “you could liquidate the gold inventory and get back twice your initial investment.”
Says van Biema, “The price of gold might fall, but how likely would it be for it to fall by 50 percent or more?”
Avoid value traps. Steering clear of value traps is probably the most difficult tip for investors to put into practice. A value trap is a stock that, by all appearances, seems to be a value stock, but isn’t.
[Read: 6 Reasons the Bull Market Won’t Go Away.]
Quite often, it’s a stock plagued by consistent underperformance, to the point where shares start looking oversold and underloved — two adjectives value investors love.
In value traps, underperformance isn’t a fluke. The company faces real, long-term challenges.
While Little says investors can’t always avoid value traps, they can minimize risk if they wait for the financials to turn around before buying in.
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5 Tips to Choosing Quality Value Stocks originally appeared on usnews.com
