How to Analyze Value Stocks: Plan Your Attack

This article on how to analyze value stocks was written by Thomas Niel. Thomas is a private investor, a financial blogger and an accountant in Washington DC. Article image (creative commons) by ND Strupler, edited by the Broken Leg Investing.

Value investing may be a simple path to big returns, but you can’t build a portfolio with a dartboard.

While investing — like poker — is the kind of game where you can develop an edge by understanding the odds, the “odds” in investing are highly subjective.

When a stock trades at a 50% discount, it is important to remember there was a seller behind that price. One person’s bargain can be another one’s value trap.

So how do you avoid this minefield? How do you stay away from weaker opportunities to find the stocks that will lead to big returns?

Read on to learn how to analyze value stocks and build a market-crushing portfolio!

How to Analyze Value Stocks: Separate Value from Value Traps

Learning how to analyze value stocks means developing a filter for separating true value from value traps.

There is more than meets the eye when a deep value stock trades at a low earnings multiple or discount to tangible book. You need to assess whether a current undervaluation foreshadows future losses and/or declines in tangible book value.

This means you need a simple yet detailed checklist that weeds out ideas historically shown to underperform, allowing you to avoid stocks that contain any of the red flags associated with unsuccessful investment ideas.

The first step to learning how to analyze value stocks is mastering these initial fundamentals to build a market-crushing portfolio.

The Market Is a Battlefield: You Need a Plan of Attack

At some point, you may have heard statements such as “most individual investors lose money,” “the average person cannot beat the markets,” and “buy index funds; why do YOU think you can beat the market?”

These statements are not entirely false: Many individual investors enter the markets like it’s a casino — they choose to speculate using ill-developed criteria rather than invest using a solid plan of attack.

Predicting the unpredictable will lead to heartache and capital losses. Developing a simple value strategy built on a solid checklist is the best path to big returns!

How to Analyze Value Stocks: Leverage a Solid Checklist

All successful value investors utilize a solid checklist built on criteria historically shown to generate market-beating returns.

Whether they are quantitative value investors such as Walter Schloss, who spread their bets widely, or high conviction investors such as Bill Ruane, who built concentrated value portfolios, the key to their success was well-developed criteria for selecting opportunities.

A solid checklist that leads to market-beating returns covers multiple variables:

  • Quantitative: Is it cheap AND safe?
  • Digging deep into the numbers, is the stock truly undervalued?
  • Are there any red flags? Why is the market discounting this stock?
  • What are the catalysts? Is there something on the horizon that will drive this stock closer to fair value?
  • Opportunity costs: Are there better buys out there?

How to Analyze Value Stocks: Is It Cheap AND Safe?

First things first: Is the stock cheap AND safe?

If you are an investor, not a speculator, this should be your first question before pulling the trigger.

Speculators chase trends and place their hopes on soothsaying to beat the markets.

Whether is it a “hot mining play,” a “disruptive technology,” or a stock dependent on a sudden social trend (legalized marijuana), speculators select stocks not on fundamentals, but on the hope of seamlessly profiting from predicting the unpredictable.

But why rack your brain trying to predict whether one Canadian cannabis purveyor will dominate the market? Why throw your chips on the roulette table that is the junior miners (development-stage mining companies)?

Value investing works because it is simple. For a strong value opportunity, you can summarize in one sentence why it is a buy:

This stock is undervalued, and this undervaluation provides a margin of safety that outweighs the stock’s inherent risks.

What Makes a Stock Cheap and Safe?

A stock is “cheap” when it trades at a discount to the inherent value of the business. This discount may be balance-sheet-based (discount to tangible book, negative enterprise value) or income-statement-based (selling at low multiple compared to peers or historical valuation).

Finding cheap stocks is the “easy” part. Fire up a stock screener, and you can find hundreds of stocks trading today either at large discounts to tangible book or low earnings multiples.

This is where “safe” comes into play: the market may be inefficient, but it is not stupid. There is typically a reason why a stock trades at an obvious discount.

There are many reasons why a stock could be selling for 50 cents on the dollar:

  • The company has litigation liabilities.
  • The company may temporarily trade at a discount to cash, but will soon require dilutive equity offerings.
  • The company operates in an uncertain international market.
  • The company has controlling shareholders not concerned with realizing underlying value.
  • The company has a history of greedy and self-serving management that erodes value.

When learning how to analyze value stocks, you will need to learn how to properly handicap these risks. Once understood, opportunities that are cheap AND have a sufficient margin of safety become more apparent.

Crunching the Numbers: There’s Always More Than Meets the Eye

Quantitative research goes beyond merely scanning a company’s income statement, balance sheet, and cash flow statement.

Mastering value stock analysis requires a critical eye that can separate “accountingese” from reality.

Accounting is more art than science. While GAAP and IFRS offer “rules of the road” for corporate managers, there are many permitted ways to “window dress” financials.

A company can generate high accounting profits — but could be hemorrhaging cash, with most of these earnings tied up in accounts receivable.

Tangible book may appear to be high — but could be largely made up of capitalized expenses that have minimal liquidation value (such as computer systems and mining development costs).

Understanding these dynamics makes it much easier to separate cash cows from money pits and find businesses that are profitable not just on an accounting basis.

How to Analyze Value Stocks: Spot and Avoid Red Flags

Learning how to analyze value stocks means avoiding the types of stocks historically shown to underperform.

When separating the wheat from the chaff, we at Broken Leg Investing use the following list of red flags to filter these out:

Chinese Operations

Run any value stock screener, and you will come across many Chinese-operating companies that trade on American or Canadian stock exchanges.

These types of stocks have a bad reputation in the markets. From incomplete information to accusations of fraudulent earnings, as well as the jurisdictional risk of investing in a country with a controlled economy, you likely have better value options elsewhere.

Exploration Firms

Exploration firms, such as wildcat oil exploration companies and “junior miners,” are a common occurrence in the American and Canadian small-cap space. Occasionally, these stocks will trade at a deep discount to their tangible books.

However, there are many caveats to this “discount” — tangible books could be just capitalized exploration expenses and may not translate into a saleable asset.

Commodity prices are also highly volatile, making investments in such names more of a bet on commodity prices — in other words, predicting the unpredictable.

In addition, exploration firms typically burn cash until they strike oil, gold, or whatever commodity they intend to extract. A bad reputation for manipulation rounds out the multiple reasons why it is best to avoid exploration stocks in your value portfolio.

Average Daily Volume Below US$1000 Equivalent

Highly illiquid stocks may also appear on paper to be a great value opportunity. The tradeoff is that these stocks are difficult to build a meaningful position with, even for a small investor. There are sometimes stocks so illiquid that a 1000-share purchase leads to a 50% rise in the share price!

The bid/ask spread in these stocks can also be extremely high, with the stock’s “bid” (price offered to sellers by market makers) presenting an undervaluation, and the “ask” (price offered to buyers) being a premium to fair value.

High Debt/Equity Ratio

High leveraged companies can sometimes appear as deep value candidates on screeners.

A common occurrence is with oil drilling and rig companies: with capital equipment and other “real property” on their books, if the business hits a downturn, the stock will appear to trade at a sharp discount to tangible book.

This does not typically make the stock a “screaming buy” — if the business is breaking even or hemorrhaging money, it will be unable to service its debt, making default a high possibility.

Unless an unpredictable event occurs (for example, a sharp rise in oil prices), these companies will more likely end up in Chapter 11 than becoming multi-baggers.

Lack of Past Earnings or a Catalyst

Many “paper value” stocks are on a long trip to nowheresville.

If a company has not shown itself to be profitable in the past, its current situation may not be cyclical, but part and parcel to a weak operating strategy.

These types of companies will likely languish as “value traps” or continue to burn cash and trade lower and lower over time. It is safe to avoid these stocks and look for value elsewhere.

Lack of Buybacks/Insider Buys

If a company’s insiders don’t see it as a buying opportunity, why should you?

You can consider it a strong endorsement that a company is trading at a discount when you see either insiders buying the stock or the company itself buying back stock.

If you see insiders selling their shares, you have damning evidence that they agree with Mr. Market’s assessment of their future value.

Shareholder Dilution

Small-cap biotech companies sometimes temporarily trade at a discount to cash (negative enterprise value) when the market has lost faith in their pipeline’s prospects.

This discount is usually short-lived. These companies quickly burn through cash conducting R&D, and in order to continue operations will likely require additional dilutive equity offerings.

These are a prime example of “paper value” and do not offer a strong value investment opportunity.

Catalysts Are King: The Importance of Optionality

When learning how to analyze value stocks, you will quickly learn the importance of catalysts that can push a deep value stock closer to its fair value within a reasonable timeframe (1-3 years).

Catalysts include activist involvement/merger and acquisition (M&A) potential, turnaround in the company’s operations, spinoffs/restructurings, and changes in industry fundamentals.

An investment idea becomes stronger when there is optionality. Having several catalysts in play can lead to a big return within a reasonable timeframe.

This stands in contrast to “binary” stock plays, which are dependent on a single catalyst, such as winning a lawsuit.

You may justify the investment as a “value play,” but before pulling the trigger, ask yourself, “Am I speculating or investing?”

Opportunity Costs: Should I Be Putting My Money Elsewhere?

When learning how to analyze value stocks, you learn selecting opportunities for your portfolio goes beyond the merits of individual security.

You have hundreds of opportunities across the globe. If you invest in companies A, B, C, and D, will you miss out on the potential of stocks X, Y, and Z?

Unless you buy the whole deep value market (not a profitable idea), there are only so many stocks you can include in your portfolio.

Knowing How to Analyze Value Stocks Is Key to Big Returns

Once you master the basics of how to analyze value stocks, you are one step further on the path to big returns.

It may take additional education, experience, trial and error, and regret before you hone your abilities, but you have moved beyond one major barrier to investing success.

You have separated the wheat from the chaff and figured out which stocks are screaming buys and which ones are only paper value.

Once understood, the initial criteria for analyzing value stocks is quite simple:

  • Focus on investing, not speculating
  • Consider stocks that are both cheap AND safe
  • Avoid common red flags that have historically underperformed
  • Catalysts are king: multiple catalysts are even better

Mastering these quantitative and qualitative filters puts you many steps ahead of the average investor and on a clear path to market-beating returns.

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