Utilize a value investing program to help you find lower-priced stocks that could soar when investors realize their full potential

There are numerous reasons as to why a value stock may be underappreciated and inexpensive. The company could have experienced a stagnant (or even depreciating) period of operations, which is why it falls into the category of “value stock.” Its business could have experienced temporarily lower sales than it had in the past because of bad publicity, legal issues, or simply lagging behind competitors.

A value stock could go through a period where most investors ignore it. But savvy investors using a sound value investing program, such the Successful Investor approach, see that there is also a great potential for it to bounce back and make an even bigger impact in the market.

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Think like a portfolio manager to get the benefits of a value investing program

As part of their stock market research, portfolio managers gather information from companies, industry studies and other sources. Good portfolio managers then try to build portfolios for their clients that make money if things go well, but won’t lose too much if their opinions turn out to be faulty, as often happens.

We do our own stock market research for our Successful Investor family of newsletters as well as our Successful Investor Wealth Management services, and we apply it from a portfolio manager’s perspective. That’s why we advise sticking to well-established companies; they tend to hold on to more value when things go wrong, or at least recover faster.

Keep your eyes open for ‘off-the-books’ goodwill to profit the most from value investing stocks 

In analyzing a company’s financial statements, a key concern, and a potential pitfall for investors, is the amount of goodwill that it carries as an asset on its balance sheet. Goodwill is an accounting entry that reflects the price that the company paid for its acquisitions, minus the value of the tangible assets, like land and equipment that it received as part of the acquisition. The term means “value as a going concern.”

In the right circumstances, goodwill can be extremely important to top-quality value stocks that meet our Successful Investor criteria, especially if it is “off-the-books” goodwill—that is, goodwill that a company developed through its own efforts, which does not appear on the balance sheet. Examples include the value of the company’s brand, or the reputation and relationship that it has built up with customers over the years.

Consider these six factors to create a secure value investing program

• 5 to 10 year history of profit. Companies that make money regularly are safer than chronic or even occasional money losers.
• Industry prominence if not dominance. Major companies can influence legislation, industry trends and other business factors to suit themselves. Minor firms, on the other hand, don’t have that power.
• 5 to 10 years of dividends. Companies can fake earnings, but dividends are cash outlays. If you only buy dividend-paying value stock picks, you’ll avoid most frauds.
• Geographical diversification. Canada-wide is good, multinational better. There’s extra risk in firms confined to one geographical area.
• Manageable debt. When bad times hit, debt-heavy companies go broke first.
• Freedom to serve (all) shareholders. High-quality value stock picks must be free of excess regulation, free of dependence on a single customer, and free from self-dealing insiders or parent companies.

Understanding the core elements of a value investing program leads to safer investing

The core of the long-term value investing approach is identifying well-financed companies that are established in their businesses and have a history of earnings and dividends. They are likely to survive any economic setback that comes along, and thrive anew when prosperity returns, as it inevitably does.

When you look for stocks that are undervalued, it’s best to focus on shares of quality companies that have a consistent history of sales and earnings, as well as a strong hold on a growing clientele.

Academic studies suggest that on average, value investing produces better results than growth investing. But these studies mostly look back on what would have happened in a particular historical period, if you followed a particular set of rules. Most distinguish between growth and income investing by looking at average p/e’s (per-share price-to-per-share earnings ratios). They assume high p/e’s are a marker for growth stocks and low p/e’s for value stocks. As any serious value or growth investor can tell you, it’s more complicated than that.

If you balance and diversify your portfolio as we recommend, it should include both growth and value selections. In both areas, however, you should avoid extremes.

Use our three-part Successful Investor approach as part of a value investing program to make better investments

• Invest mainly in well-established companies, with a history of rising sales if not earnings and dividends.
• Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry; Resources & Commodities; Consumer; Finance; Utilities.
• Downplay or avoid stocks in the broker/media limelight. When stocks spend time in the limelight, they tend to become over-priced, and this leaves them vulnerable to a sharp downturn on any hint of bad news. Instead, look for stocks with hidden value that are less widely recognized—at least so far—as attractive investments.

Some analysts believe value investing is past its prime and they favour faster growing stocks instead. What are your thoughts on this?