Lesson 22 of 43 (Value Investing): A Step-by-Step Guide to Picking the Best Value Stocks

  • “Value stocks” describes an investing strategy that looks for companies currently trading below what they’re really worth.
  • Unlike dividend stocks, small cap stocks, or a growth stocks, which all tend to stay what they are, value stocks can move in or out of being “value stocks.”
  • Over 100 years of extensive research has shown that buying value stocks is one the best strategies for making money and beating the market. Over time, it has consistently outperformed most other investing strategies.
  • We walk through a step-by-step guide to finding the best value stocks, including screenshots and direct links to a stock screener that’s pre-filtered for high-potential value stocks.

Building on our previous lesson about growth stocks, today we’re going to cover four important questions about value investing:

  1. What are value stocks?
  2. What should you know about investing in value stocks?
  3. Which value stocks perform best?
  4. How do you find the best value stocks to buy? (A step-by-step guide)

What Are Value Stocks?

What exactly is a value stock?

“Value stocks” describes an investing strategy that looks for companies currently trading below what they’re really worth.

In other words, value investing tries to buy good stocks on the cheap.

There’s no strict definition of what makes a company a value stock, and technically any company could be a value stock at any time.

For example, if a stock had a fair value of roughly $100 per share, but was trading for $120 per share we would call it “overvalued.” However, if the very next day the stock sold off by 33% so it was now priced at $80, you could definitely call it a value stock.

This is a very important point: Unlike dividend stocks, small cap stocks, or a growth stocks, which all tend to stay what they are, value stocks can move in or out of being “value stocks.”

Value stocks are in an undervalued state right now because they’re trading at a price well below what they should be trading at (based on their true fair value).

That brings us to a very important question: How do you know when a stock is trading below its fair value?

Therein lies the entire art and science of value investing.

What Should You Know About Investing in Value Stocks?

Before getting into the details of value investing, we have to cover a few very important points about what value investing is NOT:

The price of a stock, on its own, tells you absolutely nothing about whether it’s undervalued or overvalued.

We cringe when we hear investors say, “Oh that stock is trading for $150, that seems expensive.”

Or, “Hmm General Electric (GE) is only $6.70 per share? Sounds like they’re undervalued.”

The stock price only matters relative to the value of the underlying company. You have to ask what you’re getting for the price to decide if it’s cheap or expensive.

For example, shares of Berkshire Hathaway (BRK.A) are currently trading at $310,000 per share whereas shares of small cap pharmaceutical stock SCYNEXIS (SCYX) are currently trading at $1.19 per share.

We could easily argue that Berkshire trading at $310,000 ($238B in sales and $48B in income over the last 12 months) offers a much better value than SCYNEXIS trading at $1.19 ($0 in sales and -$31M loss in income over the last 12 months).

It’s not about the price of the stock. It’s about how much you get for what you pay.

Value investors try to pay a little to get a lot.

In addition, we’ve noticed that investors sometimes confuse “blue chip stocks” with “value stocks.” They’re not the same.

A blue chip stock is generally a large, well-known, high-quality industry leader with reliable financial performance and growth.

A value stock can be any company that is currently undervalued. Yesterday it could’ve been overvalued, and after a selloff today it’s now undervalued. Tomorrow it skyrockets and is overvalued again.

It’s true that value stocks often stay undervalued for a period of time and don’t tend to swing as wildly as the imaginary scenario above.

And there are value stocks that seem permanently stuck in undervalued territory. We call them “value traps” because although they appear undervalued, they often struggle to return to a fair valuation, instead languishing or declining further.

In other words, sometimes a stock is cheap for a good reason: it’s a bad business.

Classic stocks like General Electric (GE), Procter & Gamble (PG), United Technologies (UTX), Coca-Cola (KO), and Johnson & Johnson (JNJ) aren’t necessarily value stocks; they’re more blue chips stocks.

However, any one of them could certainly be considered a value stock if it’s currently undervalued.

There are MANY reasons stocks can become undervalued. Here are a few common scenarios:

  • The company reports earnings that are below Wall Street’s expectations and the stock sells off dramatically after hours.
  • Investors lump a high-performing company in with its struggling industry, selling off the entire industry even though the company is performing quite well.
  • Negative news coverage of a relatively short-term issue causes a stock to sell off excessively.
  • The media reports that a government agency is looking into the company’s business practices, causing the stock to decline dramatically.
  • A struggling company strings together a series of strong quarterly earnings reports, but investors ignore them because they have already written the company off as “in trouble.”

The savvy value investor tries to see past these short-term issues and focus on the long-term value of the company.

An investor who can do that has the opportunity to “buy dollar bills for 70 cents.”

A successful value investing strategy has three big benefits:

  1. You make money when the stock increases in price as it moves towards its fair value.
  2. You have some downside protection because the stock is already undervalued, making it less likely to go down much further.
  3. Undervalued stocks that pay dividends frequently offer high dividend yields because their steady dividend payment is now a larger percentage of their deflated stock price.

One of the reasons value investing is so powerful is because it offers investors both offense and defense.

This is why some investors (including us) believe value investing is a good strategy for all market environments, as it will provide upside offense during good times and downside defense during bad times.

Decades of extensive research has shown that buying value stocks is one the best strategies for making money and beating the market. Over time, it has consistently outperformed most other investing strategies.

There’s just one important catch:

Value investing tends to have long stretches of underperformance.

For example, classic value investing hasn’t worked very well for the last 5+ years. The market has been mostly driven by high growth stocks.

After thorough analysis on value investing, we have arrived at a surprising and controversial conclusion:

Value investing, on its own, is not a great strategy and we wouldn’t recommend it.

Instead, we’d recommend filtering out overvalued companies from all your other stock picking strategies, including dividend, growth, small cap, and blue chip stock investing.

Simply trying to find the MOST undervalued companies on the market is difficult and tends to perform poorly.

On the other hand, applying value as an added filter in your other strategies will prevent you from overpaying for dividend, growth, and other types of stocks.

Let’s look more closely at how we can avoid buying overvalued stocks.

Which Value Stocks Perform Best?

Classic metrics used to measure if a value stock is cheap include price to earnings ratio (P/E ratio) and price to book ratio (P/B ratio) which was made famous by legendary value investor Benjamin Graham in the 1930’s and 1940’s.

That being said, there are other metrics to measure value that have consistently performed better than P/E and P/B ratios.

Specifically, our research suggests focusing on these two valuation ratios has lead to strong returns over time:

  • Price / free cash flow
  • Price / sales

In addition, it can be helpful to consider these valuation metrics as well:

  • Price / earnings
  • Price / forward earnings
  • PEG ratio

All of these metrics are measuring the current price of the stock vs. the value you get when you buy.

For example, price / sales measures how much in sales per share you get for the cost of a single share.

Similarly, price / free cash flow looks at how much a share costs vs. the amount of cash per share the business generates.

They all get at the same fundamental value investor questions:

  • “Does this stock seem like it’s on sale?”
  • “Do I get a lot of strong financial performance at a cheap price?”
  • “Is the market discounting this company’s future potential?”

By using these metrics together, we can examine every stock from multiple angles to find out which are truly undervalued. 

How Do You Find the Best Value Stocks to Buy? (A Step-By-Step Guide)

As discussed above, we’d recommend applying value as an additional filter on top of your other strategies (such us growth stocks or dividend stocks). 

We wouldn’t recommend searching ONLY for undervalued stocks. 

But, since this lesson is focused on value stocks, here is a powerful value screen to get you started. In the next few lessons we show how to combine value with other key metrics. 

You can explore the pre-filtered value screener here

Notice that we’ve set strict value rules across all of our key metrics. And as usual, you can focus on large cap stocks, small caps, or any range in between.

If you decide to focus on just valuation metrics (like we did in the screener above), it makes your next step (company research) extra important.

Your goal is to answer one of the most important questions in value investing: Why is this stock so undervalued?

You may find a “cheap” company on your FinViz screen that upon further research appears to be cheap for a good reason. Maybe the company is struggling financially, undergoing a fraud investigation, or its business model is being threatened.

What you want to find are “cheap” companies that pass your screen and upon further research seem to be temporarily out of favor. These are stocks that have short-term problems or are being ignored, punished, or discounted by Wall Street.

Lesson Summary (Value Investing): A Step-by-Step Guide to Picking the Best Value Stocks

When it comes to value investing, we believe the best approach is to apply a value lens to ALL your stock selection.

So rather than asking, “What are the most undervalued stocks on the entire market?”

You should ask, “Which of these high-quality growth / dividend / blue chip / etc. stocks appear to be undervalued.”

Because a pure value investing strategy (the first approach above) is prone to such long periods of underperformance, we think you’re better off applying a dose of value to everything you do.

Here are the big takeaways from our lesson on how to find the best value stocks:

  1. “Value stocks” describes an investing strategy that looks for companies currently trading below what they’re really worth.
  2. Unlike dividend stocks, small cap stocks, or a growth stocks, which all tend to stay what they are, value stocks can move in or out of being “value stocks.”
  3. The price of a stock, on its own, tells you absolutely nothing about whether it’s undervalued or overvalued. The stock price only matters relative to the value of the underlying company.
  4. There are MANY reasons stocks can become undervalued, such as weak financial performance, government regulation, legal troubles, negative media coverage, and more.
  5. Over 100 years of extensive research has shown that buying value stocks is one the best strategies for making money and beating the market. Over time, it has consistently outperformed most other investing strategies.
  6. However, value investing can have long stretches of underperformance.
  7. Value investing, on its own, is not a great strategy and we wouldn’t recommend it.
  8. Instead, we recommend filtering out overvalued companies from all your other stock picking strategies, including dividend, growth, small cap, and blue chip stock investing.
  9. Price / free cash flow and price / sales are the best value metrics. Price / earnings ratio, price / forward earnings, and PEG ratio are also good metrics.
  10. Try to find “cheap” companies that seem to be temporarily out of favor. These are stocks that have short-term problems or are being ignored, punished, or discounted by Wall Street.
  11. You can access the value stock screen here.


Data as of 10/11/18

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Author

Todd Lincoln

Author

Passionate stock market investor with deep experience trading small cap, dividend, and growth stocks.

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