“Applying value investing to the market” is the title of chapter 15 in the 2014 book, "Strategic Value Investing: Practical Techniques of Leading Value Investors."
In it, authors Stephen Horan, Robert R. Johnson and Thomas Robinson addressed the challenge of identifying potential value stocks. They listed these three categories of resources:
- Financial publications that feature profiles of promising stocks.
- Watch what well-known value investors are doing (GuruFocus subscribers have an extra edge in this area).
- Use a financial database that allows you to screen prospective stocks (again, GuruFocus subscribers have an advantage with this service).
Financial publications
As the authors pointed out, no one has time to evaluate all the tens of thousands of prospective stock investments available. To develop shortlists, one of their resources is financial publications such as Barron’s, BusinessWeek (now Bloomberg BusinessWeek), Fortune and Forbes.
As an example, they cited the April 20, 2013 edition of Barron’s that featured an article about Chiquita Brands; at the time, the company’s stock price had fallen 40%, but it was still expected to churn out $30 million in free cash flow going forward. Seeing a story like that, a value investor would likely do some serious due diligence, including a robust financial analysis.
Researchers also take an interest in stocks featured in financial periodicals, especially those that are featured in cover stories. The Financial Analysts Journal reported on a study that followed companies featured in cover stories in three major business magazines for 20 years (1983 to 2002). The book’s authors summed up the research findings this way:
“Although positive cover stories follow periods of positive performance, and negative cover stories follow periods of negative performance, performance following publication (after adjusting for market movements, size, and industry effects) tends to be normal, for the most part.”
Interestingly, the researchers also found some companies that bought the naming rights for major league sports stadiums underperformed afterward (for example, Enron, MCI WorldCom, TWA and U.S. Airways).
Follow the gurus
If you are familiar with GuruFocus, you likely know that Charlie Tian created this website for that very purpose. There is a full section on the top menu that is titled Gurus, including a list of them, their latest picks, their portfolios, a scoreboard showing their returns over various periods and how those returns compare with those of other gurus.
The foundation for guru information is a Securities and Exchange Commission rule that all public companies and investment management companies must file periodic reports (similar bodies in other countries have similar rules).
Once this information becomes available on the SEC’s website, it becomes available for individuals, organizations and companies to access it, either directly or through third-party providers. The authors of the book referenced GuruFocus as a resource for following the gurus.
Key filings include the Form 13F Quarterly Report, which covers institutional money managers with more than $100 million under their control, the Form 13D or 13G, which must be filed by anyone buying more than 5% of a public company, and the Form 10K Annual Report (as well as Form 10Q Quarterly Report) that all public companies must file.
Screen a financial database
The authors reference two services in this section: Stock Investor Pro from the American Association of Individual Investors and GuruFocus.
In examining the GuruFocus service, they call attention to the Buffett-Munger screener (“Good Companies at Fair or Undervalued Prices”). It identifies companies with the following strengths:
- They consistently grow their revenue and earnings.
- They can maintain or grow their profit margins because of competitive advantages.
- Low- or no-debt balance sheets.
- Fairly valued or undervalued companies, based on the PEPG indicator (price-earnings ratio divided by the average Ebitda growth rate over the past five years).
They add that the list can be further narrowed with market capitalization criteria.
Other
Here are a few other considerations for value investors:
- Value traps: A low-priced stock may look good thanks to its past earnings or cash flow, but at the same time, it may be overvalued because future cash flows are forecast to be lower. Such a situation is known as a “value trap” and can be hazardous to your financial well-being. The authors wrote, “As a strategic value investor, you want to find good companies selling at attractive prices; however, you do not want one without the other. Look for companies with sound fundamentals (strong earnings, cash flow, ROE, financial position, etc.; see chapter five) and good future prospects (good products in a sound industry that will likely perform well in the expected economic conditions).”
- Asset price bubbles: We are reminded of the discussion in chapter one, in which investment is distinguished from speculation. Too much optimism can lead to rampant speculation, overvalued stocks or sectors and, in severe cases, asset bubbles. Savvy value investors who see this happening will hold on to their cash and stay out of the market for a while, or trim holdings that have become overvalued so they will be able to shop when the bubble inevitably bursts.
- Combining technical with fundamental analysis: This book has been almost entirely about fundamental analysis. But the authors recommended that investors become familiar with technical analysis as well. They wrote, “Technical analysis primarily focuses on price and value data gleaned from stock trading activity. We advise you to consider technical analysis as an add-on or supplement to fundamental analysis.” In practice, technical analysts focus on stock charts in the same way that value investors focus on earnings and cash flow. There are several benefits from the technicals that will add to an investor’s insight.
Assembling the pieces
The authors called the items on the following list “essential components of strategic value investing,” adding that the order in which they are performed may vary:
- Find potential value stocks, using the techniques listed above.
- Analyze the economic situation and develop an opinion about its direction.
- Do fundamental analyses of shortlisted companies.
- Value the company, including intrinsic value and margin of safety, and
- Buy selected companies when market prices provide a good margin of safety.
Conclusion
This chapter of "Strategic Value Investing: Practical Techniques of Leading Value Investors" showed us three methods of finding potential value stocks: reading financial publications, following the gurus and screening a financial database. As noted, the website on which you’re reading this article is an excellent resource for the latter two methods.
It also alerted us to the hazards of value traps and asset bubbles, while on the positive side, we learned technical analysis can be a helpful supplement.
Read more here:
- Strategic Value Investing: Distressed Investing
- Strategic Value Investing: Choosing Valuation Models
- Strategic Value Investing: Income and Taxes
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