With the help of Motley Fool Inside Value advisor Philip Durell, I've come to realize that there is no magic to value investing. There aren't any crystal balls. While this may seem obvious, the task of scouring all publicly traded companies hoping to find the undervalued ones can be a mystical, daunting, and head-spinning endeavor -- one that lends itself easily to procrastination.
Working with Philip and the Inside Value team since its inception, I've learned that the most important tools in the hunt for value stocks are discipline, objectivity, and patience -- not mind-reading or soothsaying.
To help you get started, I've outlined my step-by-step approach to finding value plays.
Narrow the playing field
There are more than 8,000 companies trading in the United States. While value always lurks somewhere in the market, it would be impossible to manually sift through every company's financials to determine which companies are on sale relative to their true worth. That's where stock screeners come in handy. I'm personally partial to Reuters' Power Screener, which lets me customize the features I'm searching for and make comparisons between different characteristics. When I'm screening for value, I often look for the following:
- A price-to-cash flow ratio below the price-to-earnings ratio. When a company's cash flow is in line with or stronger than its earnings, it's usually a pretty good indication that the company is not manipulating earnings through accounting gimmicks.
- The payment and growth of dividends. Dividends show that the company's managers acknowledge that they work for the shareholders, and that the shareholders deserve to profit directly from the strength of the company. Also, it is hard to fake cold, hard cash payments to shareholders, so dividends also serve as an honesty check.
- Growth of capital spending. If a company shows strong enough cash flows to exceed its earnings, manages to pay a steady or growing dividend, and has enough leftover cash to invest in expansion, then it is certainly a company worth considering.
I'll often include other, more common value-related criteria, such as a low price-to-book ratio, a high quick ratio, and a low debt-to-equity ratio, to help better tune my screen. While screening, my goal is to eliminate the obvious companies that do not fit my investing criteria, but not to narrow my list so far as to keep me from having any choices.
Eliminate the overlap
I tend to get a lot of banks in my screens. While it's comforting to know that my money is held in firms that appear to be on solid footing, I do not want all my investments tied up in banks. As I already own a part of Bank of America (NYSE:BAC), I'd rather not also buy Citigroup (NYSE:C), in spite of the fact that both banks often appear in my screens. A quick review of the results helps me eliminate the companies and industries where I've already invested, trimming the list even further.
Size up the environment
At this point, the list of remaining candidates is usually small enough for me to glance at the companies, their businesses, their competition, and the environments in which they operate. Until recently, many of my screens had repeatedly turned up auto-part supplier Visteon (NYSE:VC). Without considering the business environment, Visteon's love-hate relationship with auto giant Ford (NYSE:F), and the general malaise surrounding the domestic auto manufacturers and their suppliers, it would have been too easy to get sucked into buying a value trap, rather than a genuinely value-priced company.
Run the numbers
It is impossible to tell whether a company is value-priced without first getting a handle on what the company is worth and comparing that to where its stock is trading. A great source of financial information is the U.S. Securities and Exchange Commission EDGAR database. EDGAR stores all the required public documents on every company that is traded on the U.S. exchanges. It is a tremendous resource of the raw financial data that companies produce. The quarterly 10-Q and annual 10-K filings provide recent and historical financial views into any public company.
Any financial analysis requires digging into the financial statements and looking for trends in the data. While most companies and their auditors are honest, the trends can reveal potential signs of trouble well before management wishes them to be publicized. Some warning signs I look for include inventory building up faster than sales, accounts receivable jumping dramatically during a time of slow or even no revenue growth, or earnings growth in a time of declining operating cash flows.
Even if no major warning signs appear, analyzing the trends can help an investor determine whether the expectations for future growth appear realistic. Armed with an understanding of the business and its realistic trends, a discounted cash flow analysis can provide a valuation estimate. As daunting as that may sound, Inside Value provides an online discounted cash flow calculator to help you estimate what a company is worth. If the company is trading well below that value, a margin of safety exists, and it may very well be worth buying.
Make a decision -- and follow through
Once you determine that you've found a company you'd like to own, and that there is a sufficient margin of safety in the price, it's important to actually place the buy order. I'm embarrassed to admit it, but I let title insurance company LandAmerica Financial Group (NYSE:LFG) slip through my fingers. When I first uncovered it, it traded at $41.05 a share. Now, less than a year later, it recently traded at $54.07 a share, more than 31% above my discovery price. By waiting too long, I missed the opportunity to buy that solid company at a value price, and I lost out on some superb returns.
Wait for the market to catch up
If a company is truly a value, the market will respond -- eventually. Sometimes, the market reacts quickly. My recent purchase of employment and income verification service Talx Corporation (NASDAQ:TALX) has been quickly rewarded with a 19.6% gain in less than three months, and the market now prices the firm at approximately my fair value estimate. On the other hand, it has been nearly a year since I first bought toy giant and subsequent Inside Value selection Mattel (NYSE:MAT), and the market is only now beginning to value the firm near what I think it's worth.
While value investing is straightforward, it's not always easy to go it alone; I know I would not have learned the discipline without Philip's tutelage. I would not have had the patience to wait a year for Mattel's recovery, and I would likely have missed out on it. Even today, his guidance serves me well.
Like the idea of getting a jump-start to unlock the secrets of value for yourself? A free 30-day trial of Inside Value starts here.
Fool contributor and Inside Value team member Chuck Saletta owns shares in Bank of America, Talx, and Mattel. The Motley Fool is investors writing for investors.
