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When Inexpensive Meets Opportunity

Stocks That Aren’t Simply Cheap for Cheap’s Sake

BetterInvesting-style investors spend their time seeking growth stocks. But value investing is another proven strategy, dating back to the days of Benjamin Graham and David Dodd, authors of the seminal investing book Security Analysis in 1934. Graham and Dodd warned that anyone who paid more than 16 times earnings for a company would be “likely to lose considerable money in the long run.”

Studies of stock returns by Graham and Dodd, later by Eugene Fama and more recently by Wharton professor Jeremy Siegel all show that over time, stocks with lower price-earnings ratios outperform ones with higher P/Es. It’s also well-documented that the market has cycles that favor value stocks and ones that favor growth. Even if you don’t invest in value stocks, it’s a good idea to know something about the ways people choose them so that you can understand these cycles.
Unfortunately, choosing stocks that are cheaper than the market average isn’t as easy as focusing on a magic number such as 16. The average P/E of a stock in the S&P 500 index recently was 18.9. This suggests that any stock trading below 19 is a value stock. That might be true, unless the S&P 500 is overvalued. 
One way value investors protect themselves is to use a variety of metrics. For example, the average S&P 500 stock currently trades at 1.5 times sales, at 2.9 times book value and at 31.1 times price to cash flow. Companies that trade below most or all these metrics might make good value candidates.
In The Little Book of Value Investing, Christopher H. Browne, founder of successful value shop Tweedy, Browne & Co., warns: “All these metrics are key to identifying good prospects. But if successful investing were as simple as a mathematical formula, everyone would have nothing but winners in their portfolios.”
Stocks that look cheap but then keep dropping are known as “value traps.” The market is full of smart investors with vast resources at their disposal, so if they want to sell you, say, Citigroup at a relatively low P/E of 8.3, you might well wonder why.
Some potentially fatal afflictions a company might have include high levels of debt, an obsolete product and increased competition (especially from abroad). Citigroup’s total liabilities are over $2.2 trillion, while its total equity is just over $2.3 trillion. More bad news from the mortgage market could push Citigroup’s liabilities over its equity level. Investors might differ on how dire they believe Citigroup’s situation is, but concerns over liabilities might be a big reason why Citigroup stock trades at such a discount to the broader market.
Here’s how Browne gets beyond the numbers: After he has identified value candidates, he asks whether they’ll be able to increase prices for their products. “The less competition in an industry, the easier it is to raise prices,” he writes. Next, he asks whether the company can increase sales. A pharmaceutical company with an effective drug usually can. On the other hand, a travel agency that’s being forced out of business by online competition probably can’t. 
Then he looks for opportunities for the company to increase profit margins, especially by controlling costs. At this point, Browne’s strategy is a lot like a growth investing strategy. He might have identified stocks that are cheaper than average, but he wants to know whether they can generate earnings in the future.
One very common value technique practiced by Browne as well as Warren Buffett is to think like a company owner. This is easy for Buffett, who can buy companies outright. Without the luxury (or burden) of taking control of a company’s future, a value investor needs confidence that the company’s fortunes can improve and that management has the willingness and ability to pull off a transformation. That’s the art of value investing — the investor must determine whether a company with a strong balance sheet but whose stock is cheap will grow, stagnate or die.
There’s another way to gain exposure to value stocks that takes advantage of long-term value stock performance without all the companies’ risk. Siegel has become involved with WisdomTree, a company that offers exchange-traded funds, or baskets of stocks, weighted by criteria such as low P/Es and high dividend yields. This somewhat passive strategy seeks to capture the performance of value stocks in general.

BetterInvesting’s Online Tools

The Stock Selection Guide, the primary stock study tool of BetterInvesting members, helps you identify stocks that are reasonably priced. Our new online tool will walk you through evaluating a company using the SSG. Click on the Online Tools & Software link under the Tools & Resources menu on the BetterInvesting homepage. Your membership may already include access to the tool; if not, you can upgrade your membership to use it.

Michael Maiello, who wrote "Fly With The Fundamentals" for the January 2006 issue, is author of Buy the Rumor, Sellthe Fact (McGraw-Hill, 2004).

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