One Way to Find Deep Value Stocks

So, you think you can beat the market?

Maybe you can, but it won't be easy; because for all its vagaries, the stock market is an incredibly efficient pricing system. With millions of buyers and sellers around the world trading billions of shares every day, the quote you just pulled up on your favorite stock reflects the market's best estimate for the company's prospects and risks at that given time.

Still, an otherwise rational market can turn quite irrational to the upside or downside in the face of heightened emotions. And when the market becomes irrationally negative about a stock, therein lays our opportunity to make big profits and beat the market.

That easy, huh?
The fact that the market is generally efficient at pricing stocks, particularly larger companies like Research In Motion (Nasdaq: RIMM), Amazon.com (Nasdaq: AMZN), and ExxonMobil (NYSE: XOM), which on average trade over 10 million shares per day, makes finding stocks trading for 50% of their fair value -- in other words, a 50-cent dollar -- all the more difficult. As I've learned in my years as an analyst, if your valuation of a large company differs from the market by more than 10%, let alone 50%, your growth and risk assumptions are likely flawed.

So are you ready to give up and just buy an index fund? In the end, that could very well be the right move for you, but just stick with me for a moment longer.

The reward of buying just one or two 50-cent dollars each year is reason enough to stay tuned. They can not only make up for losses elsewhere in your portfolio, but can also provide an extra boost to your portfolio's returns when the market's doing well.

The good news is that 50-cent dollars are available in today's market. The bad news is that they're harder to find when the market's up. It takes a truly special situation to find one after the market's 60% rally since last March.  

Identify the special situation
The best way to locate a special-situation stock is to search for an anti-bubble scenario. What I mean by that is to find stocks that the market seems to have completely given up on, the inverse of a bubble where the market can't get enough of a stock.

To aid our anti-bubble search, let's reverse Woodbine Capital's three criteria to identify bubbles:

1. There is an initial, rational reason for a fall in an asset price.
2. There is one-sided pessimism.
3. Market prices imply virtually no probability of upside.

And I'll add one of my own here: The stock has to be small and under-covered by the market.

Now, think about the areas of today's market where these rules might apply. With the market higher today, it's more difficult than it was in early March 2009, for instance.

The first place that comes to mind is regional and smaller banks. Using the aforementioned criteria:

1. Many banks overextended themselves during the boom years, and now defaults and foreclosures are higher, putting pressure on loan portfolios.
2. Whether it's concerns about commercial real estate, increased regulations, or more bank failures, investors seem to think that banks cannot possibly recover, even if the economy improves.
3. The SPDR KBW Regional Bank ETF (KRE) trades with a price-to-book ratio of just 1.1.
4. Many of them are small enough that they fly under Wall Street's radar.

While not every small bank in the U.S. will survive this recession, there are others that don't deserve to be lumped in with this crowd and present us with the opportunity to find some 50-cent dollars.

Well, name names!
According to Capital IQ, 215 of the 370 U.S.-based regional banks trade for less than tangible book value. That's fertile ground for values, but this metric alone isn't enough to pique my interest -- indeed, National City and Wachovia both traded for less than tangible book before they were scooped up by PNC Financial (NYSE: PNC) and Wells Fargo (NYSE: WFC), respectively.

No, we also want to find banks with a strong Tier 1 Capital Ratio (which measures a bank's ability to absorb losses) and a positive return on assets -- however slight -- in this difficult economy.

Here are two such bank stocks to start your search:

*Data provided by Capital IQ, a division of Standard & Poor's.

To put these banks' Tier 1 Capital Ratios in some perspective, Citigroup's (NYSE: C) most recent figure is 11.7% and JPMorgan Chase (NYSE: JPM) stands at 11.1%, which gives you some indication as to the ability of the three smaller banks to absorb losses. (Above 10% is considered good.) More research into these firms is necessary before committing your hard-earned money, but it's encouraging to see that if these banks recover, based on their historical valuations at least, the upside potential is substantial.

Fire away
Buying any deep value stock, whether it's a bank, a retailer, or a drug maker is never a sure thing and entails quite a bit of risk. Like I mentioned earlier, the market is pretty efficient at pricing assets so if there's truly something very wrong with the company, the stock price may never recover.

That's why it's critical to not only do extremely thorough research before investing in a what you consider a 50-cent dollar, but also to be emotionally prepared to handle volatility in the share price. If this large risk-reward trade-off makes you uncomfortable, that's fine; it's not for everyone.

On the other hand, if you can withstand some short-term swings in hope of outsized gains, searching for 50-cent dollars might just be your thing. If it is, then simply enter your email in the box below to learn more about the Fool's new deep value investing service.