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1 Value Investing Tip That Could Earn You Thousands

By Timothy Green – Jun 25, 2017 at 7:10AM

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There's more to value investing than buying stocks that look cheap.

Value investing is dead, according to a Goldman Sachs report published earlier this month. Over the past decade, the strategy of buying stocks with the lowest valuations and selling stocks with the highest valuations has produced abysmal results, losing 15%, compared to a 60% gain for the S&P 500. Growth stocks trading for dozens or even hundreds of times earnings, the kind of stocks that make most value investors cringe, have been the place to be.

This analysis misses one key point: Value investing is not a hard-and-fast system of buying stocks with low valuations. Instead, the core concept is to buy stocks for less than they're truly worth. In some sense, value investing is the only kind of investing. Growth investors just have a different method of calculating a stock's intrinsic value, focusing more on potential and less on current results. If you buy a stock for any reason other than because you think it's worth more than the current price, you're speculating, not investing.

How can a true value investor, one who doesn't invest mechanically based on screens and spreadsheets, make money in a market that rewards growth? Here's one tip that should help.

Puzzle pieces spelling the word "value."

Image source: Getty Images.

Buy cheap stocks, not cheap-looking stocks

Most of the time, a stock trading for a below-average multiple of earnings or book value or sales is cheap for a reason. The company may be having problems, or the industry may be in upheaval. The intrinsic value of any stock depends on the company's future, not just its present. Paying five times earnings for a stock only to have those earnings turn to losses in short order is a recipe for disaster, not a prudent investment.

There is no shortage of cheap-looking stocks available. Retail is one area rife with them -- no surprise given the current disruption driven by e-commerce and the overbuilding of stores. Retail stocks trading at or near single-digit multiples of earnings are a dime a dozen. But a retailer trading for what looks like a bargain valuation is only truly a bargain if it has a future. Will department stores like Macy's (M 0.20%), dependent on 40% gross margins and heavy advertising, survive in a world where apparel sales are moving online? I honestly don't know.

Macy's stock trades for around 11 times last year's earnings, and just 5 times its peak earnings from 2014. A dividend yielding nearly 7% entices investors, and the company has real estate holdings that, if sold, could bring in billions of dollars. There is a value case for Macy's, but only if the company doesn't fall into ruin. Similar arguments could have been made about Sears Holdings ten years ago; acting on those arguments would have been a disaster.

Video game retailer GameStop (GME -1.98%) is another example of a stock that looks cheap but probably isn't. Shares trade for just 6 times last year's earnings, and the dividend currently yields 7.4%. But GameStop's core business of selling physical video games is going to disappear sooner or later, once the major game console makers adopt a digital-only stance. PC gaming long ago went digital, and it's only a matter of time before consoles follow suit.

GameStop is trying to adapt, diversifying into selling electronics and collectibles. But the company, and how it makes money, will be completely different ten years from now. Valuing the stock based on earnings produced from a line of business that isn't likely to survive doesn't sound like a good idea to me.

A true value stock is one that trades for less than it's worth, based on both its current financial situation and its long-term prospects, calculated conservatively. That last condition is critical -- any stock can be made to look like a great deal, if optimism is pushed to the extreme. Tesla looks like a steal if you assume it's the next Apple. It looks like a farce if you assume it's the next Ford.

The bottom line: All "value stocks" aren't created equal. If a low valuation is the only reason you're buying a stock, there's a good chance you're making a mistake, unless the price is so low that nearly any scenario leads to profits. Most cheap stocks are cheap for a reason. But floating in that sea of value traps, there are the gems that make value investing worthwhile.

Timothy Green has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Apple, Ford, and Tesla. The Motley Fool owns shares of GameStop and has the following options: short July 2017 $24 calls on GameStop. The Motley Fool has a disclosure policy.

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