Million-Dollar Homes at Half-Price

Some things we know in our heads, and other things we know in our bones. Great investors understand, deep in their bones, the importance of seeking value, while people like me 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. For example:

• 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 been sidetracked. For instance, after many years of wanting to own a company because I so admire it, I may just jump in and buy some shares, even though it may not be trading at a very attractive price.

If you're anything like me, it helps to remember what you should pursue when investing. Here's an explanation from Century Management's Arnold Van Den Berg from a past 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 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 most of us can only reasonably own a small subset of them. 

It's best to seek out the ones trading at low valuations, because they tend to offer the most upside potential. For example, in both 1992 and 1993, you and I might have agreed that IBM was a terrific company with great long-term prospects, despite some temporary hiccups.

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's around $100. 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 that would still be an estimate, wouldn't it?

You might also use stock screens to turn up candidates for future research. At Motley Fool CAPS, for example, I recently screened for companies with gross profit margins of at least 30%, trailing-three-year earnings-per-share growth rates of at least 10%, and price-to-earnings ratios (P/Es) 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 can indicate a cheap-to-fair valuation.

Here are some companies that popped up from that screen:

Source: Motley Fool CAPS. TTM = trailing 12 months.

This bunch looks promising, but I'd never buy a stock like this without doing a lot of further research, since the list is based solely on three quantitative factors. (Remember, for example, that trailing P/Es look only at past earnings, so if future earnings fall, P/Es will rise over time, even if the share price doesn't move up.)

Seek guidance
If you want some help in trying to identify and research good value stocks, consider tapping (as I have) the expertise of those who do, such as our Motley Fool Inside Value team. I invite you to take advantage of a free, no-obligation trial of Inside Value, which gives you 30 days of full access to all past issues and in-depth write-ups for every recommendation.

Further Foolishness:

• The Perfect Investments for This Market
• This Is Why Buffett's Buying Stocks
• 3 Companies That Beat Buffett's