Easy Steps to Becoming a (Better) Value Investor: Part 2

View Part 1 of this article, Margin of Safety.

If you've ever been accused of being a contrarian, a naysayer, a negative Nancy, or a Debby Downer, you may be a great value investor. In contrast to our growth-y friends, we value peeps love to think about the worst thing that could happen. We say "no" a whole lot more than we say any other word. The next big thing is just the next big thing to avoid. When someone asks us if we want to hear about this investment idea they have, we may politely indulge, but secretly we already don't like what they have to say. Value investing isn't the easiest method of investing. But when broken down to the basics, it is a very doable, logical process that you can start practicing today and be on your way to investing like the world's greats.

Like an old prospector
Many a value investor will tell you having more than 30 holdings at any given time puts you at risk of what Warren Buffett calls "diworsification." While there are plenty of investors with 80 to 100 stocks in the portfolio and decent returns, I like to quote James Oelschlager, an institutional money manager: "No hospital wings or college dormitories have ever been named after an indexer."

It means that, sure, you can buy the S&P 500 (SPY) and earn your 5%-6% in a normal year -- there's nothing wrong with that, and you can sleep at night knowing your money is relatively safe. But if your interest is to outperform the market (and, more importantly, capital preservation), then you're better off with a few chosen gems that you have stumbled across from hours upon hours of turning over rocks.

I typically advocate anywhere from 10 to 20 stocks, many of them stocks no one has heard of and no one cares about. It sounds daunting -- turning over so many rocks to find one gem, but it's a lot easier than you think.

Lesson 2: 1,000 rocks
When asked how he finds stocks, Warren Buffett once said, "I start with the 'A's." With thousands of stocks on the exchanges, it may be a little too much to start with the A's these days, but you can still use a similar strategy. One way I like to go hunting for stocks is to choose a sector I know and love -- say, for instance, retail -- and run a screen. Reuters has a great screening tool for retail investors to use. For this lesson, I'll choose retail companies with P/Es anywhere from 0 to 50 (sometimes the screens can be a little inaccurate, so I set a wide range and recalculate certain metrics myself), EPS growth greater than zero, and a PEG under 5.

The screen gives me only 140 stocks. For the average investor, these 140 stocks can be sifted through for any interesting picks before lunchtime. I'm not currently a fan of Asian and African stocks, because of the fraud risk, so I throw those out. This immediately narrows my scope to 109 stocks.

At a quick glance, I see a company I know and have looked at in the past: Advance Auto Parts (NYSE: AAP). I can tell that the company has taken a dip recently because of a negative quarterly report. Quarterly reports should be almost completely irrelevant to the value investor, or any long-term investor. But they can be advantageous in getting a stock price down below its intrinsic value. I see that in May the stock was trading above $90 per share and then dropped sharply to less than $70 per share today. Briefly looking at key statistics, I see that the return on equity is a very appealing 44%, suggesting management might be doing the right things. Short-term earnings growth, as we saw, is negative, but free cash flow has been increasing for the past three years in a steady manner. For a retail company like this one, I look to free cash flow as one of the most important elements in the equation.

It looks as if the company has been taking on a decent amount of debt, possibly for expansion or restructuring. If I've decided this stock is worth a closer look, I'll write down the ticker and dive into the specifics later on.

Going through 109 stocks in a couple of hours sounds awful, but you can weed out the junky companies so easily that it really takes no time at all. You don't have to stick to names you know -- I just cling to certain sectors and peruse the thousands of stocks every few months for anything that catches my eye.

It works
Screening isn't the only tool for sifting through the myriad of available investments, though it's a great starting point. I found one of my favorite companies of all time, Winmark (Nasdaq: WINA), through an average screen. Winmark owns a variety of second-hand stores selling everything from musical instruments to baby clothes. It's a low-risk, high-cash-generating business with a phenomenal management team. When it first popped up on my radar with a low P/E and high inside ownership, I took a closer look and found an amazing, incredibly simple company. Since early 2011, the stock has gone from less than $35 per share to nearly $55 and a newly instated dividend.

Have most people heard of Winmark? No -- there's no reason to. That's partially what makes it so attractive to a value investor like myself. Value guys love the underfollowed, the unloved, and, of course, the undervalued.

Stay tuned for the next installment of this series -- they'll keep comin'. In the meantime, check out this special free report about some of the best value investors in the world and what they -- including a certain Mr. Buffett -- are buying.