Value investing in a nutshell refers to buying stocks that are undervalued by the market, with the assumption that the market will eventually price them at their full value, making you money in the process. However, over the past several years, the market has gone up and up with no significant correction, making it tougher to find these "bargains." How can we find value no matter what the market is doing?
Make your list
There are two strategies you can use to get started in value investing. You can either search for companies that are a great value right here and now, or you could wait until the companies you want to own become great values.
For the first option, a good place to start is to run a stock screen through your brokerage account for stocks that meet certain criteria. The average P/E ratio of the S&P 500 is currently about 18.7, and a quick search shows there are 35 companies on the S&P with a P/E of less than 12. From this list, you could determine which company has the highest intrinsic value and growth potential and narrow your choices down.
Or let's say all of the companies you really want in your portfolio are too expensive. If you want to own a company like Under Armour, for example, but think it's too expensive at nearly 60 times earnings, formulate a target price where you would consider the business to be cheap. One rule of thumb I've used is to double a company's growth rate and shoot for a P/E of less than that amount. In our Under Armour example, it would become a value play for you at a P/E of less than 56 (28 times 2).
Over time, you'll formulate your own criteria for value plays, but you definitely need a way to quantify what's "cheap" and what's not.
Value investing can help in bad times
We keep hearing that a correction is coming, so what happens if it does? Well, with value stocks, the whole point is they're already cheap, so they should be well positioned to deal with any market drops. For example, one stock I believe represents a great value play right now is AT&T (NYSE:T). Despite a projected average annual growth rate of 7% for the next three years, shares trade for just 10.6 times trailing earnings, and they also pay a 5.1% dividend yield.
On that note, dividend stocks are a good starting point for finding value plays, as the dividend creates a sort of "price floor." If, for example, the S&P 500 plunged by 50%, AT&T would likely fare much better, as such a steep drop in its share price would result in an extremely high annual dividend rate of more than 10%; buyers would begin to swoop in, and the price would rebound.
AT&T also has a somewhat recession-resistant business. The company is the second-largest U.S. wireless carrier with around 116 million subscribers, and the wireless business does fine in bad economic times. People will always have a need to communicate, and in the company's only year of declining revenue in the past decade (2009), sales were off by less than 1% from the year before, and earnings were off about 2% from 2008 to 2009. Compare that with the average S&P 500 company, which saw its earnings drop by over 50% during the recession.
AT&T has also shown that it is willing to adapt to the changing times and give consumers what they want. For example, the company is constantly upgrading its network to adapt to higher data usage, and its upgrade program was found to be the most cost-effective for consumers in a recent study. AT&T is also an ambitious company for its size, with tremendous growth potential in its U-Verse television and Internet services. In fact, U-Verse revenue is nearly 20% higher than it was a year ago.
Value vs. growth
So what makes a value stock different from a growth company? Essentially, a growth company's appeal is not necessarily based on the intrinsic value of the business, but rather its long-term growth potential. Many growth stocks do not turn a profit, and many that do trade at extremely high P/E ratios. Growth stocks are also much less likely to pay a dividend, instead believing their earnings are put to better use by being reinvested in the business.
A great example of a growth stock is Amazon.com (NASDAQ:AMZN), which, despite its nearly $75 billion in sales last year, doesn't make much of a profit yet. From a valuation standpoint, Amazon's P/E of more than 450 may look downright ridiculous. However, Amazon's revenue is still growing at a tremendous rate, and the most recent quarter represents a 23% year-over-year increase. The analyst consensus calls for earnings to increase nearly tenfold by 2016, to more than $7 per share from 2013's $0.76 per share, and some estimates are much higher.
If Amazon's sales growth continues at the current rate, it would mean nearly a trillion dollars in annual sales in a decade. If that were to happen, today's share price could seem ridiculously cheap. However, Amazon's "business" itself isn't worth a tremendous amount today, simply because it doesn't earn much money. Maybe it will someday, but then again, maybe it won't. That's what makes it a growth stock.
Growth stocks like Amazon rely more on projections for their valuation, and therefore they're much more sensitive to economic dips and are more volatile in any market environment. Once Amazon begins to mature -- which you'll be able to recognize through stabilizing sales growth and consistent profitability -- it could then transition into a value stock, as we've seen with Apple over the past few years.
Follow the rules and you'll be OK
If you do your homework and value the companies you would like to own and then stick to the plan, you'll have a tremendous advantage no matter what the market does. Value investing is a tried-and-true strategy that works in any market.
Matthew Frankel has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.