6 Values in an Overheated Market

Despite the market's recent stumbles, the S&P 500 is up more than 65% since the lows of last March. That's an extreme run by any measure. And whether you think this is a maturing bull, or simply a bubble brought on by all the stimulus money dumped into the world, the idea of finding value in this market is starting to seem like a lower-case-f fool's game.

Or is it?

I don't think it has to be … as long as you know where to look.

Finding value in bubbilicious times
Like I said, I don't know whether this is a bubble or a bull (and neither does anyone else … yet). But if we buy value, we stand a good chance of making money no matter what the market does. And I think there are purchase-worthy values to be found. Consider:

• "The market" is not a monolith. The S&P 500 and other market indicators are averages. As with any average, there are outliers. Some stocks have gone way up. Some haven't. Some of the ones that haven't are cheap for good reasons (declining sales, massive lawsuits, tragic clown-related incidents). And some are good companies that are cheap because they've been overlooked, or because their sector has been out of favor.
• There's almost always true value out there. There's always "relative" value to be found -- stocks that look cheap relative to others' current prices. One could do worse than to just buy a handful of those and hang on to them for a year or three. But at moments when the market could take a turn for the worse, finding stocks that are underpriced relative to their intrinsic value -- one share's worth of the best-guess true value of the company -- gives us a good chance of making money over the next few years no matter what.

The key: A margin of safety
A stock that is priced lower than its intrinsic value is said to have a margin of safety, a key concept in value investing. Of course, it's not as simple as it sounds, as any calculation of intrinsic value is at best an educated guess. (Here's an example: How much is Toyota's (NYSE:TM) brand name really worth right now? I don't really have more than a vague guess, and I follow Toyota pretty closely. See what I mean?)

But even so, seeking a margin of safety as we look at stocks keeps us focused on what matters most: not losing money. A stock that will go up if things go well, but won't go down much if things go badly, is a beautiful thing to own, especially in turbulent times.

Another key: Counterintuitive thinking
One shorthand definition of value stocks is "stocks that have been overlooked by the market". Sometimes that's because the company is obscure, or in an industry that isn't receiving much attention at the moment. Finding a good company under those conditions can often prove very profitable.

Sometimes, though, it's because of bad news, and our tendency is to turn away from such companies. But companies that are through the worst of the actual bad news -- but maybe not through the worst of the bad taste that news left in investors' mouths -- can sometimes make excellent buys.

Toyota is a great example of a company that is seeing a lot of bad news. But the company isn't going away, and at some point this string of embarrassing disclosures will come to an end. That point will come before Toyota's reputation recovers, and that point might well be a good time to buy.

These stocks are worth a closer look
I wouldn't jump on Toyota just yet. But I just ran one of my favorite value screens and turned up some intriguing possibilities. These are all companies that have low debt, a relatively low price-to-earnings ratio, solid return on equity, and favorable ratings from the Fool's CAPS community -- four of my favorite indicators when I'm looking for new values.

Source: Motley Fool CAPS.

It's an intriguing list. Of those companies, the one I'd look at first is probably the small -- but exceptionally well-positioned -- Neutral Tandem. The stock has been beaten down due to concerns about competitive pricing pressures, yet the company just reported a great quarter, with operating income up 36%. They've got no debt, almost $5 a share of cash in the bank, and a price-to-free-cash-flow ratio that's a third of their industry's average -- all signs of quality management.

But to be clear, Neutral Tandem and the other stocks listed above are just promising possibilities turned up in a screen, not formal buy recommendations. With any value candidate, taking a careful look under the hood is a must before making the trade.

If you don't have the time or inclination to take those closer looks yourself, but you'd like some carefully vetted value ideas to buy today, take a moment to check out the Fool's Inside Value newsletter service. You can see the team's best ideas for new money in just a few seconds with a 30-day free trial.