Million-Dollar Homes at Half Price

Some things we know in our heads, and others we know in our bones. I suspect that great investors understand the importance of seeking value deep in their bones, while people like myself often just pay it lip service.

I write about money for a living. I know many principles of successful investing, I can proclaim them with great confidence, and I really and truly believe them:

• Invest for the long haul.
• Over long periods, stocks outperform most other investment vehicles.
• Look for companies with lasting competitive advantages.
• Focus on value; invest in great companies when they're undervalued.

Still, every now and then, I've gotten sidetracked. For example, after wanting to own a company for many years because I admire it so, I may just jump in and buy some shares of it, even though it may not be trading at a very attractive price.

If you're anything like me, it can help to remind yourself of what you should pursue when investing. Here's a great explanation from Century Management's Arnold Van Den Berg that I ran across in a recent issue of Outstanding Investor Digest:

It's kind of like if you went to the best part of town and could buy a house for less than you could in the worst part of town.... In the stock market, most people don't understand value. And there are a lot of people who are buying stocks for reasons other than value. Therefore, you wind up with these valuation discrepancies.

That echoes the thinking of Philip Durell, advisor for Motley Fool Inside Value:

As value investors, we believe that the market can overreact to news, both good and bad. We take a long-term view of a company's business, so we dig into price disparities as we scan for punished companies that the market may have driven down for no good reason.... A good working definition of a value stock is one that can be bought for a price that offers a big enough margin of safety that if you are wrong in your analysis or if there are fundamental shifts in a company's strategy, you are protected from losing much money.

Application time
If you're ever tempted, like me, to snap up shares of an impressive company at a less-than-impressive price, think again. Remember that a lot of terrific companies are out there, and that most of us can only reasonably own a small subset of them. Therefore, it's best to seek out the ones trading at low valuations, since they tend to offer the most upside potential. For example, in both 1992 and 1993, you and I might have agreed that IBM (NYSE:IBM) was a terrific company with great long-term prospects, despite some temporary hiccups.

If you don't want to click through to the link, here's the short version: IBM was down, but not out. In July 1993, its stock dropped all the way to $10 per share. Today, it tops $110. It was a great value play back then, but I, along with many others, didn't act on it.

So now that your dedication to value-oriented investing has been reaffirmed, what should you do? Seek out healthy, growing, and undervalued companies. That's easier said than done, though. You might do it by spending many hours on complex discounted cash flow calculations, projecting future earnings, and applying discount rates to them. But even that would still be an estimate, wouldn't it?

You might also use stock screens to turn up candidates for future research. At Yahoo! Finance, for example, I recently screened for companies with net profit margins of at least 10%, trailing-five-year earnings growth rates of at least 10%, and price-to-earnings (P/E) ratios of 20 or less. The first two factors help me zero in on attractive companies (growing briskly with robust profit margins), while a relatively low P/E ratio can indicate a cheap-to-fair valuation. Here are some companies that popped up from that screen:

This bunch looks promising, but it still requires a lot of further research, since the list is based solely on three quantitative factors. (Remember, for example, that P/E numbers tend to vary by industry, so a P/E of 15 might be steep for a automaker but low for a software developer. Don't rely on screens alone.)

Seek guidance
If you don't have the time to devote to stock analysis, consider tapping the expertise of those who do (as I have), such as our Inside Value team. I invite you to take advantage of a free, no-obligation trial of Inside Value for 30 days, giving you full access to all past issues and in-depth writeups for every recommendation.

In the meantime, continue to seek out solid values whenever you spend your dollars.

This article was originally published on April 19, 2007. It has been updated. 

Longtime contributor Selena Maranjian owns shares of Johnson & Johnson and PepsiCo. Chesapeake Energy is an Inside Value recommendation. Johnson & Johnson is an Income Investor recommendation. Disney is a Stock Advisor recommendation. The Motley Fool is Fools writing for Fools.