This article on finding good value stocks with tremendous upside was written by Josh Klein. Josh is a private investor and a commercial real estate analyst from New York City. He combines balance sheet health with operational efficiency in his personal account. Article image (Creative Commons) by 777546, edited by Broken Leg Investing.
The stock market is a maze of uncertainty, continuously surprising those who try to navigate it. You have thousands of companies to choose from, hundreds of analysts to listen to, and millions of articles and SEC filings to read. This leads to an overarching question for all who venture into the market — how do I pick good value stocks?
One must narrow down the world of stocks in order to properly answer the question and hone a sound investment approach. Look at the world from a bird’s eye view, and you’ll see two main investment categories emerge: growth and value.
Growth Stocks Vs. Good Value Stocks
Growth stocks represent the companies that have the ability to propel their revenue and earnings power into the future at rapid and high rates. Customarily, new technology powers growth stocks to help the company disrupt any dormant industries and complacent competitors. Facebook, Netflix, and Amazon are a few good examples of growth stocks. Over the past few years alone, they’ve grown at extreme rates, sometimes eclipsing 40%-50% revenue growth per year, mostly due to technological advances and increasing product popularity amongst consumers. Growth investors focus primarily on “tomorrow” rather than the here-and-now of a company’s operations and financial security.
The typical definition for value stock is a stock trading below the intrinsic value of the enterprise it represents. Although good value stocks could share certain characteristics with growth stocks — such as promising future growth and unique technologies — they are typically categorized based on current market conditions and assessed based on the stock’s price relative to its true value.
By definition, growth stocks have within them built-in speculation. A growth investor might buy Stock A because they believe the company will enter new markets, develop new technology, or sustain its current growth rates into the near future. A value investor, on the other hand, only purchases a stock when it trades below their assessment of the company’s fair value — i.e., stocks trading with a margin of safety.
Margin Of Safety
The wise value investor must buy good value stocks with a significant margin of safety. This allows the investor to steer clear of speculation and venture into the mercurial markets with a slight edge. Buying at a discount gives investors ample cushion in the event that an unforeseeable occurrence surfaces. Doing so protects against the downside while partaking in any potential upside swings.
However, how does one determine an appropriate margin of safety sufficient enough to render a stock worth purchasing? As a deep value investor, there are a few different ways to answer this question. Perhaps the stock is trading significantly below its book value, indicating that the stock is worth more than its potential liquidation value. Maybe the company has a negative enterprise value and has more cash on its books than it has in assets and liabilities combined. Purchasing these deeply discounted stocks gives investors plenty of cushion to help them sleep well at night knowing their principal investment is protected.
Unfortunately, it isn’t that simple. These deeply discounted companies usually trade at such low levels for good reason. Perhaps the company suffered a major litigation claim, putting its future operations at risk. Maybe the company had to close down an international factory, causing much uncertainty. Or, perhaps the company’s management has continuously sucked the balance sheet dry and eroded any and all of its value over the years. It’s easy to filter for these deep discounts. Avoiding zombie firms is the hard part.
Zombie firms are exactly how they sound. They are walking-dead companies that continue to erode value year after year. They are value traps that cause keen investors to slip up time and time again by burning cash without any turnaround plan in place. The successful investments amongst deep value securities are generally troubled companies, so how does one find the good value and toss aside the zombies?
Watch for these three key character traits that can make the difference between huge profits and disappointing returns:
- Insider Ownership
- Controlled Cash Burn
- Near-Term Catalyst
Cash-heavy undervalued companies will remain undervalued unless management has incentive to unlock shareholder value. Take a closer look at SG&A costs and management compensation. A red flag to consider is if C-suite executives receive hefty paychecks regardless of their underlying performance. If, on the other hand, insiders purchase more shares, aligning their interests with the shareholders’ interests, the company might be poised for future growth. Insider ownership is essential for avoiding zombie firms.
Controlled Cash Burn
Companies trading below liquidation value could scream opportunity, but companies below liquidation value that erode value every quarter should be avoided at all cost. Understanding the company’s cash balance is essential for avoiding zombie firms. Analyze the firm’s receivables and cash conversion cycle. If receivables constantly increase, but the company's cash balance steadily declines, it could be a sign that the firm is increasing sales without collecting revenue appropriately. The seemingly good value investment will quickly turn to zombie level before you have an opportunity to unlock value.
Although the mere fact a stock trades in deep value territory can be a catalyst in and of itself, oftentimes a deep value opportunity can stay at its price point for long periods of time. However, if a company has a near-term catalyst — defined as value-unlocking news — that could help tremendously in capital appreciation. Perhaps a company is about to come out of a serious litigation claim or bring on a new major customer. It is important to monitor the breaking news to determine if good value stocks could turn into a moneymaker instead of a walking-dead investment.
The three characteristics listed above are just a few pointers with immense value-revealing potential. Undoubtedly, many other deep value investors will have other strategies they employ to avoid zombie firms. Most deep value opportunities are beaten down, unloved, and left to rot. They are downtrodden companies with only a glimmer of light in them. Most, if not all, news sources will tell you the future is bleak and the glory days are over. Frankly, most of the time they are right. But, if key markers such as insider ownership, cash control, and near-term catalysts are revealing an opportunity and the investment can be bought at a significant margin of safety, don’t listen to the noise. Be a contrarian. Venture into territories where others won’t. Invest with conviction. If you build a portfolio with these stocks, you’ll surely be able to maximize returns, minimize downside risk, and avoid zombie firms entirely.
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