In my last commentary, Beat the Street With Value, I made my case for value investing. To quickly sum up, I'd rather have $33,630 in profits, compared with $16,520 for growth stocks and $7,471 with the S&P 500.
Today, as promised, I'll outline how I hunt for value for my Inside Value newsletter. I generally break the field down into six areas:
- Wounded elephants
- Former glamour stocks
- Fallen angels
- Bankruptcy survivors
- Stealth stocks
I always keep an eye on the industry stalwarts, the stocks that most people want to own because they have the financial muscle to withstand stormy weather and can provide steady, predictable earnings and cash flow growth over a long period. The trouble is that these characteristics are well-known, and I usually find such companies overvalued.
Once in a while, however, these companies fall temporarily out of favor, and I wait, like a patient big-game hunter, to see whether one of these wounded elephants will come into my price range. Often, it will be after a bad quarter or two, the expiration of a patent on a blockbuster, or some other bad news that will have the institutional investors dumping the stock. This is quickly followed by analyst downgrades after the stock price has fallen. The market psychology dictates that it almost always overreacts, which gives value investors their opportunity. A classic example was Altria
Today, a sector that interests me in this category is large pharmaceuticals. As the pressure builds to find cheaper alternatives to patented drugs and as blockbusters come off patent, the press is almost all negative about the group as a whole. I'm not talking about special cases such as Merck
I'm also hearing that the blockbuster model is broken, but I don't think so. Wall Street expects blockbusters to roll off the assembly line -- as one goes off patent another should take its place -- but it doesn't work like that. In my opinion, Glaxo and Pfizer have the best R&D, long-term pipelines, and alliances with smaller pharmas and biotechs. On a P/E basis, big pharma is cheaper than it's been for a long time -- maybe not quite cheap enough, but I'm watching.
Cyclical companies have inconsistent earnings, and, consequently, a look at their stock price chart resembles a roller coaster ride. The key here is that the industry cycle is predictable. Natural resource companies, chemicals and other industrials, automobiles, and, more recently, semiconductor manufacturers and generic pharmaceuticals fall into this category. When shopping among the cyclicals, I usually stick to industry leaders with rock-solid management and strong balance sheets. It's notoriously difficult to forecast the U.S. and global economies with any degree of precision. Strong balance sheets help companies stay afloat if a downturn persists longer than expected.
A good example of a classic cyclical company is Inside Value Watch List stock Intel
Generic pharmaceutical companies such as Teva
Former glamour stocks
David Gardner loves glamour stocks over at his Motley FoolRule Breakers newsletter, and so do I, but for a completely different reason. I know David has been successful in the past spotting companies such as AOL and Amazon
Don't think for a moment, however, that story stocks cannot be values. Just last year, I salivated over Home Depot
A former story stock that I've been watching is Krispy Kreme Doughnuts
Next week, I'll continue the hunt for value by outlining the Fallen Angels, Bankruptcy Survivors, and Stealth Stocks. If you are intrigued by value investing and can't wait until then, why don't you try out Inside Value, with the first 30 days on me? No charge. There, you will be able to join the Value Team and me in our discussions and access all current and previous issues. We can talk about the market, your favorite value picks, and those on my current Watch List.
So, I wish you good value investing until we chat again.
Philip Durell is the analyst for the Motley Fool Inside Value newsletter. He owns shares in GlaxoSmithKline, and his wife owns shares in Home Depot.