Million-Dollar Homes at Half-Price

Some things we know in our heads; others we know in our bones. Great investors understand, deep in their bones, the importance of seeking value. People like me often simply pay it lip service.

I write about money for a living. I know many principles of successful investing, 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 been sidetracked. After many years of wanting to own a company because I admire it so, I may just jump in and buy some shares of it, even if it's not 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.

Now apply that knowledge
If you're ever tempted to snap up shares of an impressive company at a less-than-impressive price, think again. A lot of terrific companies are out there, and most of us can only reasonably own a small subset of them. Thus, it's best to seek out those 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. 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'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 spend hours running 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. Using the screener at our Motley Fool CAPS service, 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 15 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.

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

Seek guidance
If you want some help in trying to identify and research good value stocks, consider tapping the expertise of those who do -- including our Inside Value team. You'll get full access to all past issues, and in-depth write-ups for every recommendation, when you take a free, no-obligation trial of Inside Value for 30 days.

For great advice about value investing, turn to Warren Buffett. Fellow Fool Morgan Housel recently told readers about Buffett's best advice ever.