Notice any stocks that are getting pummeled as a result of embarrassing headlines or negative rumors? They might be the next great value stocks.
Value investing isn’t as simple as that. But that’s sort of the mentality.
“Be greedy when others are fearful,” legendary value investor Warren Buffett once said. His advice still rings true.
Sometimes good companies get wrongly punished by the stock market, often to the point where they become undervalued. But not just any company receiving a bit of bad news qualifies as a good value play. Instead, value stocks typically share a couple of key characteristics.
- Strong growth prospects. Every stock takes it on the chin at one point or another. The companies whose sales and earnings to grow through it all are the ones that consistently bounce back. It doesn’t take much for a stock to get knocked down—a disappointing new product, a scandal involving one of its executives, a bad Super Bowl ad. Those are temporary problems. For savvy value investors, they’re also prime buying opportunities.
- Cheap multiples. There are ways to actually measure value stocks. And it’s not as simple as looking at the price to earnings (P/E) ratio, as some analysts might have you believe. Price to earnings is just one of six valuation benchmarks we use. The others are price to book value, price to cash flow, price to dividends, price to sales and the PEG ratio, which is calculated by dividing the current stock price by the last four quarters of earnings per share growth. For a company to be considered a strong value stock candidate, at least one of those ratios needs to be low. If several of those valuation multiples are low, and earnings are projected to grow, then you may have found a stock that is trading well below its intrinsic value.
Even with those characteristics in place, successful value investing still depends a lot on timing. You don’t want to invest in a strong value candidate while it’s still in free fall. You want to buy value stocks right around the time they’ve hit rock bottom—or at least close to it.
Determining where that bottom isn’t an exact science. Rarely, if ever, are you going to get in at the exact right time. A simple rule of thumb is to adhere to Benjamin Graham’s “Margin of Safety.” Graham, universally recognized as the father of value investing, said the Margin of Safety is achieved by buying a stock only when it’s trading below its maximum buy price, thus minimizing potential losses. The maximum buy price is determined by taking the median consensus high estimate for the stock.
To learn more about maximum buy prices, Margin of Safety, and other Benjamin Graham-influenced philosophies on value investing, read the Cabot Benjamin Graham Value Investor by our own Roy Ward. Roy is a second-generation disciple of Benjamin Graham. In 1969, Roy developed a computerized model of stock selection based on formulas created by Benjamin Graham, and since 2003, he’s been spreading his wisdom far and wide as chief analyst of the Cabot Benjamin Graham Value Investor advisory.
If you’re looking for good value stocks and want a little help, few people are more qualified to point you in the right direction than Roy.
Each write-up features commentary on the picks from one or more of our expert stock market analysts, as well as company details and a stock chart.