Smart investors always look for stocks that give them good value for their money. Yet traditional value investors took a big hit during the bear market. And even though many have seen their portfolios recover during the rally, they're still second-guessing whether value stocks are the best place to invest right now.
Fallout from the financial crisis
Value stocks enjoyed their heyday throughout much of the decade. Most of the high-growth potential at the turn of the millennium was centered on technology stocks, most of which subsequently crashed during the tech bust from 2000 to 2002. By comparison, even though the broader market also suffered significant losses during that period, traditional value havens like financials and consumer-oriented stocks held up well.
During the bull market that followed, value stocks continued to perform well. The boom in housing combined with low interest rates to support financial stocks, which still sold at attractive valuations compared to the rest of the market. Not only did stocks like Citigroup
Then, of course, the bottom fell out. Housing tumbled, pulling financials down with it. Several mutual fund managers who emphasized a value philosophy reflexively bought financial stocks when they fell, believing a rebound was inevitable. Yet many of them underestimated the magnitude of the financial crisis and suffered huge losses.
Finding real value
If professional value investors can be as wrong as they were during the past two years, you might wonder how an ordinary investor can do better. The key lies in finding stocks that offer the perfect combination of several desirable traits. Here are four things you should demand from any value stock you own.
1. An excellent business model
Too often, value investors get bogged down in share prices. But the first thing you should look for when seeking good value stocks is a company that stands apart from its competition. Whether it has a durable competitive advantage like eBay
2. Scorn from the popular crowd
Ideally, the best time to buy a stock is when some catalyst has unfairly beaten down its share price. A stock like Starbucks
3. Cheap by any measure
Especially during recessions, it's easy to get trapped by false values. At times like these, when current earnings have pretty much no predictive value at all, you should look closely at other measures as well. If share prices look attractive compared to book value, annual sales, and free cash flow, then the odds are good that you have a strong value candidate.
4. Strong investors on your side
Perhaps the most important thing to look for in a value stock is whether you have company insiders on your side. In the best case, you'd like to see corporate leaders having retained a significant financial stake in their company, preferably with unrestricted shares that they never offered to the public instead of free grants of shares or cheap options. Stocks like Cal-Maine Foods
It's tough to find stocks that meet all four of these criteria. When you do, however, you can have confidence that you've found a true value stock. As long as you don't compromise what's really important to you, you'll find that despite the temporary setbacks that many value adherents have suffered lately, value investing is still alive and well.