If you own stocks, you know that you have to take some risks in order to earn long-term riches. But while those who jumped headlong into the recent rally have seen their daredevil tactics succeed brilliantly so far, the right combination of prudent risk-taking and self-preservation will help you survive no matter what the future brings.
Plenty of people see themselves as smart value investors right now. But even though you can find plenty of beaten-down stocks in the market, that doesn't mean that anybody who's buying those stocks right now is really using value investing principles. In fact, plenty of what's going on in today's market looks a lot more like speculation.
Manage your risk
But the nice thing about the current market environment for true value investors is that many stocks offer both the potential for strong returns and some protection against further declines. Sticking with stocks that offer this margin of safety distinguishes value investing from simple bargain-hunting and low-priced stock speculation.
That margin of safety can come in several different forms:
- Some companies have substantial holdings of cash and other short-term investments net of their debt -- in some cases so much that the company's per-share net value is higher than the stock's current market value.
- Other stocks sell at valuations that imply that their underlying businesses are doomed to failure, when in fact they're likely to continue operating for some time -- even without any real prospect for growth.
- Still others are somewhat pricier but have valuations that reflect the belief that a company won't grow, despite some real opportunities for new growth in the future.
So which category of value stocks should you look for? The answer depends on your risk tolerance.
What you can find
As you'd expect, stocks in the first category above -- sometimes known as Graham net-nets, after Benjamin Graham, who is credited with pioneering the strategy during the Great Depression -- are hard to find. In general, such stocks tend to be extremely small, and many are often burning their cash in an effort to grow, making their net-net status a temporary phenomenon.
It's much easier, however, to find decent prospects in the other two categories. Consider some of the results of a simple screen that looks for low current and forward P/Es with reasonable estimates of future growth:
|
Stock
|
Current P/E
|
Forward P/E
|
Estimated 5-Year EPS Growth Rate
|
|
NRG Energy (NYSE: NRG )
|
4.0
|
7.6
|
10.4%
|
|
Fairfax Financial (NYSE: FFH )
|
6.1
|
8.9
|
15%
|
|
Coventry Health Care (NYSE: CVH )
|
9.3
|
8.3
|
12.5%
|
|
Tesoro (NYSE: TSO )
|
5.6
|
9.1
|
14%
|
|
Cash America (NYSE: CSH )
|
7.7
|
5.9
|
12%
|
Source: Yahoo! Finance intraday on 5/21/09.
Now bear in mind that relying on overly simple measures like P/E ratios and projected growth rates involves a multitude of dangers. Analyst projections are often downright wrong, and earnings figures are subject to accounting-related adjustments that don't always reflect the economic reality a company faces.
But taking those warnings into account, you can divide this group of companies into two categories. Those companies that have current P/E ratios that are lower than their projected forward P/Es -- a common phenomenon in cyclical industries -- have shareholders expecting to see contracting earnings in the near future. Yet their valuations are so low that even if their businesses only produce stable earnings in the coming years, they're still reasonably priced, with earnings yields well above 10% in a low-interest rate environment.
Meanwhile, some companies trade at attractive valuations even though the market sees substantial growth both now and in the future. For them, growth that even approaches what investors hope to see could produce strong gains in share prices.
Take the safe path
Now it's true that value plays like these haven't seen the same gains that those who picked up shares of Bank of America (NYSE: BAC ) and AIG (NYSE: AIG ) have earned since March. Yet while those buyers took a substantial risk that those financial firms could fail entirely -- and still bear that risk -- companies with a greater margin of safety typically didn't fall as far. So while that means they won't give you the same 2- or 3-baggers that other stocks have seen, you may also avoid the big future drops that threaten your entire portfolio.
You can't profit without taking risk. But if you limit yourself to taking smart risks, you'll end up saving yourself in the long run.
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