Value investing: Simple strategies for finding value

Buy low, sell high. This simple adage sums up the value investing philosophy. But in practice, value investing is far from simple. Done right, it involves in-depth investigation of a company’s business, industry and competitors; a valuation of its assets and cash flows; and complex quantitative analyses of its financial results and stock performance. For everyday investors, a true value approach can be daunting.

Yet there are some simple strategies available to those who wish to pursue the value approach that can help them identify stocks that pose particular promise.

Value Defined

Value investors look for stocks whose intrinsic value is greater than their current price. They seek companies that have fallen out of favor but still have good fundamentals. Value stocks are considered bargain priced compared with book value, replacement value or liquidation value. Typically, value stocks are priced much lower than stocks of similar companies in the same industry. This lower price may reflect investor reaction to recent company problems, such as disappointing earnings, negative publicity or legal problems, all of which may raise doubts about the companies’ long-term prospects. The value group may also include stocks of new companies that have yet to be recognized by investors.

Stocks that may be undervalued share two critical qualities: strong fundamentals and attractive valuation metrics.

Fundamentals

Benjamin Graham, the father of value investing, advocated a disciplined approach for identifying stocks with value. Critical to this approach is a familiarity with the business of the company you are investing in. You should be knowledgeable about what the company sells, how it operates, what the competitive environment is like, who manages it, and what its threats, opportunities, strengths and weaknesses are.

A good place to start is with businesses or industries you know or are interested in. Knowing a company’s products, customers, competitors and operating environment is essential in identifying its intrinsic value, and the more familiar you are with it, the better. Does the company have some unique competitive edge? Does it dominate its market? Is it in a sector or industry poised for growth? These factors can be key to future growth.

Next, narrow down the field by screening for companies that have a history of strong and consistent financial performance. Look at short- and long-term trends in sales and earnings, as well as cash flow. Also consider the company’s debt levels and cash position. And if the stock pays dividends, look at yield and consistency.

Financial characteristics that value investors typically look for include:

• Strong balance sheets with little or no debt
• High coverage of fixed charges, debt service and dividend payments
• Strong or improving operating margins
• Consistent growth in sales and earnings per share
• High return on equity or return on assets relative to peers

A company’s financial statements and an analysis of its financial results can be found in its annual report, or its SEC filings, which are available through the SEC Web site.

Valuation Metrics

A number of different valuation ratios attempt to gauge a stock’s “priciness” by looking at the stock price as a proportion of its earnings, sales or book value (equity). These metrics can be used to compare the valuation of different securities and help determine how expensive a stock may be in comparison with comparable issues. Typically, value stocks are priced much lower than stocks of similar companies in the same industry. So with each of the following metrics, look for low values in comparison to peers or industry averages.

The most widely used valuation metric is the price-to-earnings (P/E) ratio. It is calculated by dividing a company’s closing price by its historical or projected per-share earnings over a specified period. Note that P/E ratios will differ depending upon what earnings are used. Often, analysts use projected earnings to compute this ratio, since stocks are traded on future expectations rather than past results.

Similarly, the price-to-sales (P/S) ratio is calculated by dividing a company’s closing price by its historical or projected sales. The price-to-book (P/B) ratio represents the closing price divided by the company’s book value, or common equity, per share.

The PEG ratio (P/E ratio divided by projected annual earnings growth rate) is a widely used value indicator that also factors in earnings growth. A low ratio relative to its peers indicates that the stock may be undervalued.

Another commonly used measure is to look at where the stock price stands within its price range over the past year. Although, by itself, it does not mean the stock is over or under valued, it can be helpful in gauging the overall price trend.

The Realities of Value Investing

As an overall investing strategy, value investing has had a varied track record of performance. In comparison to a growth investing strategy, value has outperformed in only 10 of the past 25 calendar years. Value stocks did outperform growth in each of the six years from 2001-2006, and again in 2012 and 2013 (through September 30). But growth stocks outperformed value stocks each year from 2007-2011.¹

Growth Versus Value—Historical Comparison¹

Both growth and value stocks have taken turns leading and lagging one another during different markets and economic conditions.

Value investing typically requires a long-term commitment. The gains to be realized from investing in an undervalued company can take years to materialize. A ten or more year holding period is not uncommon. Likewise, cyclical shifts that favor a particular industry or sector can take years to occur. It may take a long time for undervalued stocks within these areas to realize any gains from sector rotation.

It’s also important to keep in mind that buying undervalued stocks is inherently risky. Stocks with low valuations tend to be low for a reason. They may be experiencing financial difficulties, management problems, regulatory challenges or any number of issues that represent legitimate reasons for avoiding the stock. What’s more, it is easy to mistake a market downturn for a value buying opportunity. Just because a company’s stock price or P/E is heading downward does not mean that it is undervalued.

That said, a value investing strategy can be lucrative if done right. Just ask Warren Buffet. The key is applying a thorough review of all prospective issues and a consistent strategy. But it’s not easy. It takes a lot of time and effort to research companies, let alone value them. That’s why it’s best to work with a professional, who can help you identify undervalued companies or value funds. With the backing of Morgan Stanley global equity research, I can help you add value to your portfolio.

¹ Source: Standard & Poor’s. Stocks are represented by the annualized returns of composites of the S&P 500/BARRA and S&P 500/Citi Growth and Value indexes, which are unmanaged indexes considered representative of growth and value large-cap stocks. The S&P 500 Growth and Value Indices each represent 50% of the market capitalization of the S&P 500 index. Stocks are assigned to the growth and value indices in proportion to their growth and value attributes. Index performance results do not take into account the fees and expenses of the individual investments that are tracked. Results include reinvested dividends. Past performance is no indication of future results. Individuals cannot invest directly in an index. (CS000170)

Thomas Alley is Senior Vice President – Wealth Management with the Global Wealth Management Division of Morgan Stanley in the Denver Tech Center.  He can be reached at 303-925-9705 or thomas.j.alley@mssb.com.