Value investing is buying stocks that are perceived as being worth more than what you pay for them. Stocks are valued most commonly by the net tangible assets of the companies they represent, earnings per share, and dividends they pay. Thus, a value investor would favor those stocks that have low price/book ratio, low price/earnings ratio, and high dividend yield.
However, it would be dangerous to go out and buy any stock that meet these criteria, as a stock that appears cheap may in fact be on the brink of bankruptcy and not a bargain at all, despite the figures. Sorting out between the true bargains and the false bargains, or value traps, is not easy. Here are some things to look for that may help you to make the distinction with caution.
Stay clear from stocks that have dropped in price due to to exposed corporate fraud. Some recent examples like Enron, Worldcom, and Tyco have experienced marked drop in prices that make them look like bargains after their scandals were exposed, but in the end they’re in a relentless trajectory to zero, leaving shareholders with nothing. Wherever fraud is involved, the figures in the financial statements that are used to determine value are meaningless, and the company simply cannot be valued appropriately. Moreover, once a fraud is discovered, the company tends to have little, if any, value left that has not already been stolen by corrupt management. Do not touch stocks of companies involved in corporate fraud with a ten foot pole!
Beware of overly optimistic guidance from the company’s management. A company that promises to deliver smoothly increasing double digit earnings growth is unrealistic, and such promises, when they become undeliverable, may lead to fabrication of figures by the management. Warren Buffett bought huge stakes in Freddie Mac during the 1980s when the stock was truly cheap, but liquidated his position for a $2.75 billion profit during the late 1990s, after he saw signs that the overly optimistic guidance by the company’s management was unachievable.[2]
Avoid companies with high debt or leverage. Debt or leverage is a double edged sword. In good times, you can make twice as much money using leverage and borrowing is easy; in bad times, you lose money twice as fast and the time when you need the money the most is when creditors start calling you and demanding repayment of the debt.
For a good margin of safety to make sure a company is able to satisfy interest payments on its debt, look for companies with at least two to four times interest coverage (earnings before interest at least two to four times interest charges). Upper limit applies to industrial issues, especially cyclical ones; lower limit applies to more stable incomes such as utilities.
A company with no debt is highly unlikely to go bankrupt, barring unforeseen misfortunes such as massive legal settlement against it, or inability to sell its products for more than it costs to create those products (evidenced by negative net income on the income statement). On the other hand, excessive leverage can destroy even a great company.
Avoid companies that have fallen due to outdated products and services. Blockbuster is a good example: who needs to go to a physical store to get videos or DVDs when they can be download at home with the click of mouse? Likewise, newspaper and physical bookstore businesses have been hurt by the expanding internet. Outdated products and services often signify that the lost revenues are probably lost forever, and that a rebound in the stock price is unlikely.
Be careful of companies facing increasingly stiff competition. Look at the profit margins (net earnings divided by revenue) of a company through a period of 5 to 10 years, and also compare to profit margins of competitors in its industry. If the profit margins are decreasing through the years, that usually signifies that the company is unable to pass increasing costs onto its customers due to competitive prices. If a company is no longer competitive with its competitors, better to avoid it despite the low valuations.
Be careful of companies in highly regulated industries. High fees and regulation costs in the U.S., for example, have forced many companies to relocate their business to other countries like China or face extinction. Most consumer goods are no longer made in USA. Payday loans are another example. Making $20 in fees for every $100 loan due in 2-3 weeks is great while it lasts, until the government caps the maximum interest charges to 36 percent per annum, and the payday loan companies find themselves unable to generate a profit anymore given such regulations.
Be careful of investing in stocks that have dropped due to a dividend cut, especially when the company does not expect to resume dividends any time soon. Dividend cuts usually means the company has no earnings to pay out. The price correction following a dividend cut can be prolonged. Wait till the valuations are really compelling, such as significant price drops that send the stock to 50 percent or less of its intrinsic value, before plunging in.
Watch out for missed earnings estimates. Analysts are generally quite lenient in their estimates and tend to revise their estimates downward before earning release to allow companies to beat their estimates and look good. Occasional missed earning estimates with over reaction in the price is a solid reason to buy on the dip, but a pattern of missing earning estimates is foreboding.
Invest in profitable enterprises only. Look at the company’s income statements dating back at least the past five to ten years. A consistently profitable company should have at least some earnings per share for each of the past five to ten years, preferably with a upward trend. A company with consistent negative earnings every year may be too expensive at any price.
Look for insider buying. Insiders are in the best positions to know how much their company is truly worth, and if the stock price is truly cheap, they will be buying the stock. There is only one reason why insiders buy: they expect the stock to go up. If you see recent history of insider buying, it’s a safe bet to follow suit. On the other hand, if you see many insiders selling, it may be an ominous sign and you should probably keep your hands off.
Check the balance sheet to make sure the company is healthy. One of the most important thing to look for that that the company should have current assets greater than current liabilities, to ensure that it can pay its bills in the short term. A more stringent test is to calculate the quick net asset by subtracting inventory (which may be illiquid) and total current liabilities from current assets. Alternatively, determine the quick current ratio by dividing (total current assets – inventory) by total current liabilities, and make sure the ratio is greater than one. Another measurement of financial health is the debt to equity ratio, obtained by dividing total liabilities by total equity plus capital surplus. Debt to equity ratio should preferably be less than 1; the lower, the better.
