Important Updates for Investors
Carla Pasternak's Premiere Issue of High-Yield International Just
Released
Income expert Carla Pasternak's debut issue of High-Yield
International covers a Taiwanese manufacturer yielding 9.5%... a
rare Mexican monopoly yielding 13.4%... and other top-performing
investments yielding up to 19.0%.
Government's Biofuel Timetable Could Spell +15,900% Growth
+15,900% growth might seem far-fetched... but it's not. In fact, it
is mandated by law. And I've identified the ONLY stock positioned to
capture this growth.
The
Silver Lining to a Falling Dollar
Despite the U.S. national debt, there is a silver lining for income
investors. This massive spending, combined with movement out of U.S.
Treasuries, is going to take its toll on the dollar, and
international income investors could reap the rewards in the form of
higher dividends. |
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| Building
Your Own Value Investing System (Part II) |
Published: October 4, 2005
In Part I of this
article, which I published back on September
28th, I laid out the case for value investing and showed you why it
is one of the most popular and widely-followed strategies on Wall
Street. In today's lesson I'll bring you a closer look at some of the
specific methodologies that I use to uncover quality value candidates.
Before I continue any further though, please keep in mind that
individual investors should strive to develop their own unique process
for finding undervalued stocks. While my ideas should serve as a good
starting point, readers should customize the model to fit their own
personal risk tolerance levels, preferred holding periods, and other
various financial circumstances.
The process I use to identify winning value stocks can essentially be
summed up in three steps:
Step #1: Screen the entire universe of stocks
against predetermined filters. This step is designed to narrow the
immense field down to a workable number of potential investment ideas.
Step #2: Of the stocks that make the final cut,
determine the intrinsic and strategic value of those that look most
promising.
Step #3: Build a diversified portfolio of those
stocks that are trading at the sharpest discounts to their true value.
While these three steps may sound relatively straightforward in theory,
applying them in the real world takes a bit more work. For starters,
there is no set blueprint for selecting the parameters used in the
initial screening process, and some filters will undoubtedly be more
effective than others in pinpointing undervalued stocks. Furthermore,
pinning a precise number on a company's intrinsic value is an inexact
science. Even complex valuation techniques such as discounted cash flow
analysis require a certain amount of guesswork. Finally, while the
primary objective of value investing is to find mispriced stocks, I also
look for other attributes -- such as turnaround stories, buyout targets,
companies with new products, valuable real estate assets, and anything
else that could serve as a catalyst to unlock shareholder value.
Step #1 -- Screen the entire universe of stocks against predetermined
filters
Starting with a broad universe of more than 10,000 publicly traded
stocks, the first step I take is to trim back this field by excluding
those that fail to meet my stringent value-oriented criteria. Investors
lacking the necessary software can use one of the free stock screeners
found online through providers like Yahoo or Morningstar. It should be
noted, though, that while screening is an effective tool to help speed
up the search process, it will also invariably eliminate a number of
attractive companies that may be worth a closer look.
For example, suppose you have been following a growing biotechnology
company with a promising new drug in clinical trials. At the current
time, this company may not clear one of your investment hurdles -- such
as Price/Sales. However, it is quite possible that the new drug could
dramatically ramp up sales in the near future. In cases such as this, I
wouldn't rule out otherwise solid candidates simply because they come up
short based on one arbitrary criterion. Remember -- screens can be
tremendously helpful, but be aware that they can also leave some
potential gems undiscovered.
One of the first ways I narrow the field is by eliminating very large
companies. With much heavier trading volumes and a contingent of equity
analysts following their every move, large-cap firms are more
efficiently priced -- meaning there are few opportunities to find stocks
trading at just pennies on the dollar. For this reason, I find the
small- and micro-cap arena to be more fertile ground for uncovering
undervalued and overlooked stocks. I suggest beginning with an initial
maximum market capitalization of around $100 million.
Setting this limit will reduce the pool of potential ideas to
approximately 3,000 -- a good start, but there is still plenty of room
to pare back even further. One possible way to do this would be to
exclude companies from certain sectors. For example, you may already own
a technology-focused mutual fund and have no need for further exposure
to that area. Or, perhaps you think that the outlook is relatively poor
for the utilities sector. Whatever the reason, emphasizing or
eliminating certain sectors is an easy way to let your personal
preferences, background, and interests help frame your investing
strategy.
For some investors, sector selection doesn't factor into the decision
making process. However, most will find that they are naturally
predisposed to having a better understanding of and affinity for certain
industry groups. There is much wisdom in the old adage "buy what
you know." On the other hand, of course, I would caution against
following it to the letter, as having a portfolio that is heavily
concentrated in just one or two industries can be highly dangerous. The
link below offers a complete list of the entire industry index from
Yahoo:
http://biz.yahoo.com/ic/ind_index.html
Step #2: Of the stocks that make the final cut, determine the
intrinsic and strategic value of those that look most promising
Now that the field has been narrowed to include smaller companies that
operate in preferred industries, it is time to dig even deeper and begin
looking for stocks that are trading significantly below their intrinsic
or strategic value.
To begin, I take the first candidate and weigh it against all other
companies that operate in the same industry. Because ratios can vary
widely from sector to sector, it is important to maintain an
apples-to-apples comparison by judging a stock primarily against its
peers. For example, a Price/Sales ratio of 1.0 might be considered
reasonable for a computer manufacturer, but would be on the expensive
side for a grocer.
Income Statement:
One of the best places to begin is at the top of the income statement
with revenues. Typically, I will rank from least to most the amount that
investors are forced to pay for each dollar of sales. Consider the
following example:
| |
Market
Cap |
2004
Revenues |
Price/Sales |
| Company #1 |
$6M |
$3M |
2.0 |
| Company
#2 |
$10M |
$10M |
1.0 |
| Company #3 |
$1M |
$2M |
0.5 |
In this case,
strictly based on Price/Sales alone, Company #3 appears to represent the
best value, as investors must only pay $0.50 for each dollar of revenues
the firm earned last year. By contrast, shares of Company #1 are trading
at four times that level.
I should also point out that while Price/Sales is a commonly-used
financial ratio, I prefer to measure sales (among other measures)
against Enterprise Value. Enterprise
Value is a figure that factors in the value of a firm's equity, cash
and debt, making it a truer reflection of a firm's real "price."
Like almost any other metric, valuing a company based on its revenues
has its advantages and its drawbacks. Revenues are much more difficult
to manipulate or distort than earnings, which makes them a fairly
reliable benchmark. In fact, there have been statistical studies that
have illustrated the important role that top-line growth plays in
growing a business. However, looking at Price/Sales or Price/Enterprise
Value in isolation can be very misleading, as companies with very low
ratios tend to also have very thin profit margins, meaning only a tiny
percentage of those sales trickle to the bottom line.
For this reason,
it is also important to analyze the next major line item on the income
statement -- gross profits. Gross profit represents the amount of income
left over from total revenues after subtracting cost of goods/services
sold. Often, I will find companies that generate substantial gross
profits and maintain healthy gross margins, but still have trouble
showing a net profit. Investors often ignore companies with negative
earnings, which allows the value hunter an opportunity to pick up these
stocks at bargain prices.
Eventually, some of these companies will identify ways to reduce their
overhead costs or trim other fixed expenses, which will in turn let more
of those gross profits flow through to the bottom line -- and hopefully
lift the share price. Thus, money-losing firms that manage to
consistently generate high levels of gross profits will often have a
head start on achieving overall profitability.
With so many investors focusing exclusively on net income and
overlooking gross profit, I believe the latter can be a powerful measure
to help spot hidden value before the rest of the market catches on. In
general, I prefer to invest in stocks that are trading at less than
three times annual gross profits.
Finally, after ranking each of the firms in the chosen industry
according to revenues and gross profits, I then repeat the process with
net income. Keep in mind, though, that the impact of non-recurring
charges may need to be stripped out. When the earnings picture is
clouded by a series of one-time items, adjusted earnings from continuing
operations may offer the best insight into where the company is headed.
Also, don't forget to assess the impact of taxes. Some companies may be
carrying forward tax losses from prior periods, which reduces current
taxes and inflates earnings. In these cases, take a closer look at how
much earnings will fall when this temporary tax benefit runs out in
future years.
Note: In the coming weeks I'll bring you Part III of
this educational series on value investing. In it, I'll take a closer
look at how to analyze a firm's cash flow statement and balance sheet.
I'll also summarize many of my methodologies and will show you how you
can use them to uncover highly undervalued stocks.
-----------------------------
Important Note: The above article
was merely a small excerpt from a recent issue we sent to subscribers of
our premium value investing service -- Margin-of-Safety
Investing. In each issue of that newsletter, editors Nathan
Slaughter and Paul Tracy deliver an in-depth look at a variety of other deeply discounted
stocks that should provide investors with a solid margin of safety at
current prices. To receive your copy of our most recent issue of Margin-of-Safety
Investing, as well as other guidance similar to this twice per
month, you'll need to subscribe to this publication. To learn more,
please visit:
https://www.streetauthority.com/subscribe-msi.asp
Thanks for reading!
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Nathan Slaughter
Editor
Half-Priced Stocks, The ETF Authority
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in-depth guidance on today's leading value opportunities, plus educational guidance, please subscribe to
Nathan Slaughter's premium value investing newsletter --
Half-Priced
Stocks |
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Investing Doesn't Get Any Easier Than This |
Stock picker Amy
Calistri's strategy is as simple as investing gets -- just one idea
a month designed to make money in today's market. Invest this way
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Go here to learn about Amy's simple investing strategy.
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