Value investing, the art and science of buying stocks at a discount to their intrinsic value, is a great way to approach the market at times when it's looking a bit overheated (like right now). As legions of great value investors from Warren Buffett on down have proven over the years, there's nearly always value to be found in the market, even when all of the big names look overpriced.
An effective quick screen for value
But how do we find it? One of my favorite ways to find value stocks involves the screen advocated by hedge fund manager Joel Greenblatt in his (excellent) The Little Book That Beats the Market. Greenblatt's idea was to boil the stock selection process down to simple metrics that answer two big questions:
- Is the stock cheap? Greenblatt screens for earnings yield, which is essentially a more sophisticated version of the price-to-earnings ratio favored by old-school value investors. Greenblatt's favored calculation of earnings yield is a little complicated, but the simpler method that most stock screeners use -- earnings per share divided by stock price -- will get us in the ballpark. Greenblatt looks for stocks yielding more than 10%.
- Is the business a good one? As we all know, sometimes cheap stocks are no value -- they're cheap for a reason! Greenblatt screens for healthy businesses by looking at return on assets (ROA), the company's after-tax profit divided by the value of its assets (factories, inventory, etc.). Generally speaking, a high ROA is a sign of a well-run business. Greenblatt looks for an ROA of 25% or more.
It's a simple screen, but like most screens, it's not foolproof. Greenblatt deals with that by recommending a systematic investment approach -- run the screen once a year, invest in several of the recommended stocks, sell the following year, and repeat. Personally, I don't do that. (You can if you like; it works pretty well if you follow it strictly and give it time. Read the book to learn more.)
Instead, I run the screen, then take a closer look at the most promising companies that show up. And that's exactly what I did when I was looking for stocks to buy recently.
Three intriguing stocks...
Here are a few of the names that turned up on my screen:
Cirrus Logic (Nasdaq: CRUS ) . This integrated-circuit developer sports an earnings yield of more than 17% and an ROA of almost 54% ... and fortunes that are tied closely to none other than mighty Apple (Nasdaq: AAPL ) , which includes a Cirrus audio chip in its iMac product line. Cirrus has been a highflier, but the company's stock price took a whack in April after a quality issue (since resolved) led to missed earnings. That has the makings of a perfect value situation, and I think this one's worth a much closer look.
Power-One (Nasdaq: PWER ) makes power inverters for wind and solar energy companies, and has been gaining market share in this intriguing corner of the alt-energy space. An earnings yield of almost 14% suggests that it's still reasonably priced, and an ROA around 26% suggests solid management. Fool Jim Mueller took a close look recently and ended up adding it to his Rising Star Portfolio. Take a few minutes to learn more about this one.
Momenta Pharmaceuticals (Nasdaq: MNTA ) . Full disclosure up front: I ended up buying this one myself last week. At first glance, generic-drug maker Momenta looks like a wannabe in a space dominated by big names. But unlike most low-margin generic drugmakers, Momenta has the scientific capabilities to make generic versions of highly complicated drugs, like its copy of Sanofi's (NYSE: SNY ) blockbuster anticoagulant drug Lovenox. While there's a risk that other makers could step up and compete in its space, it's a formidable player, with a big cash hoard, no debt, a good pipeline, and savvy management. (Its ROA is almost 61%.) And it's fairly cheap, with an earnings yield around 11.6%. Take some time to learn about this one before buying, since it's something of a special situation -- but still, I like the odds.
...and a useful lesson
Of course, as we all know, sometimes "value" stocks are cheap for a reason. With an earnings yield greater than 14%, and an ROA of almost 30%, Blackberry maker Research In Motion (Nasdaq: RIMM ) would seem to be a prime buy candidate ... until you look a little further. For me, this is a prime example of "cheap for a reason," a company with management issues and a stagnant product line that has been leapfrogged by competitors. It's one "value" that I plan on avoiding.