Here's an approach your inner cheapskate ought to love: value. If you want to populate your portfolio with picks that appear to be trading at a significant discount to their forward-looking prospects, value is right up your alley.
Dialing for dollars
Some penny-pinching investors favor high-quality stocks that trade at discounts to earnings-growth expectations and generate loads of free cash flow. More aggressive investors, on the other hand, may be willing to target distressed companies -- including those with accounting or regulatory woes -- to really score a steal. They invest on the theory that troubled times can be good opportunities for bargains.
Free cash flow (FCF) is a central concept for many value lovers. In the strictest, most straightforward sense, FCF is simply the figure you get by subtracting capital expenditures -- such as the sum a company might lay out to acquire a fleet of new paper shredders -- from the cash it has taken in from business operations.
Buying quality on the cheap
In general -- and for beginning investors in particular -- I favor the more conservative style of value investing. Scraping the bottom of the barrel for markdowns can be fraught with peril; just ask folks who bought Enron when it looked cheap. And while there's no guarantee that even stalwart stocks won't fall any further, clever investors can at least do the math to mitigate as much risk as possible.
In addition to FCF, home in on the following data points to gauge whether a prospective value investment is worth exploring:
Price-to-earnings ratio (P/E): Relative to a company's reported earnings over the past 12 months, how much have investors bid up a stock? As investing great Peter Lynch has explained, you can think of the ubiquitous P/E as the number of years it would take a company to earn back the amount of your investment. The higher the P/E, the higher the hurdle.
Industry and market P/E: As critical as a company's P/E is, it isn't especially revealing in isolation. Compare and contrast the company's multiple (as geeky types call price ratios like the P/E) to that of both the broader market (as measured by the S&P 500) and the firm's industry average. As a rule, value investors will gravitate toward stocks with P/Es below those of rivals, and in many cases, the broader market's average as well.
Five-year earnings-growth forecast: Being a value investor doesn't mean giving up on growth; investing skinflints just want to pay as little as possible for it. As Fool value guru Philip Durell put it in his Inside Value newsletter service's inaugural issue, his mission involves "scouring the market for that company trading for $0.50 on the dollar."
Ideally, you should strive to buy growth on the cheap, gauging a company's expected rate of earnings expansion relative to rivals. You should pay a P/E premium only when it will buy greater growth. And remember, it's entirely possible to find the best of both worlds -- stocks with industry-surpassing forecasts and below-average P/Es.
Avoiding value traps
One danger with value investing is that a stock might actually deserve its discounted multiples. Short-term irrational exuberance (or despair) aside, the market mostly deserves its reputation for efficiency. So how should you proceed when sifting through the market's unloved? Here are three tips to avoid sinking your money in the Wall Street equivalent of quicksand:
- Make 'em show you the money: Cash is simply much harder to fudge than quarterly earnings reports, which are often so riddled with "one-time" charges that it's difficult to make accurate year-over-year comparisons. Focus instead on free cash flow.
- Follow the bouncing ball: If a company's cash flow pattern is erratic or on a downward path, consider yourself warned. True, there may be a benign explanation -- a product launch didn't happen as scheduled, for instance -- that could clarify the firm's moribund multiples. But if there's no rational short-term explanation for the cash flow jitters, the stock might still have a long way to fall.
- Favor stability: All else being equal, favor businesses with lengthy track records of cranking out cash and delivering for shareholders.
If you're looking for ways to protect yourself from market downturns while picking up good stocks at reasonable prices, it's time to anchor your portfolio to value stocks. Want some help? Our Motley Fool Inside Value newsletter has lots of insight, analysis, and stock recommendations for you to follow. You can check it out absolutely free with a 30-day trial.