What are value stocks truly worth? The answer depends on a number of factors, including hidden assets and profit potential

What are value stocks? The best value stocks are low in price and high in potential.

One of the sweetest and most profitable pleasures of successful investing is to buy high-quality value stocks—stocks that are reasonably priced, if not cheap, in relation to their sales, earnings or assets—and then hold on to them as mainstream investors recognize the value and push up the share price.

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Q: What are value stocks? A: Investments that have the following characteristics

Pat: Bargain or value stocks will typically trade lower than their financial fundamentals suggest. They are perceived as undervalued, and have the potential to rise.

Some investors look only for companies that fall into the undervalued category. These investors are less likely to invest in a growth stock because they feel that a value stock will eventually reach its full potential once it is recognized by the market.

Generally speaking, the climb is steadier for a value stock. The exception is if it transforms into a growth stock, perhaps by being more aggressive and innovative with its products or services.

Q: What are value stocks vs. growth stocks?

Pat: 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 value investing by looking at average p/e’s (share-price-to-earnings-per-share ratios). They assume high p/e’s are a marker for growth stocks and low p/e’s are a marker for value stocks. As any serious value or growth investor can tell you, it’s more complicated than that.

At the same time, if a stock seems like an exceptional bargain in relation to earnings or asset values, it may suffer from hidden risks. The stock can plunge when those problems begin to take their toll.

For that reason, value investments may only be cheap due to hidden problems.

Q: What are value stocks truly worth? Possibly more than expected due to hidden assets

Pat: Look for hidden assets when evaluating value stocks. These include, for example, real estate on the books at historical values. If you buy a stock for its hidden assets, but those assets stay hidden or ignored by investors—or turn out to be less valuable than you thought—it can’t hurt you much. By definition, a stock’s hidden assets have not had much impact on its price. If you paid little if anything for the assets, you have little to lose. But the best hidden assets will eventually expand a company’s profit, grab investor attention, and push up its stock price.

Stocks with hidden assets are not rare, but they’re hard to find. When you know what to look for, however, you can discover them.

Here are three financial ratios we use as a guide to evaluating stocks, especially value stocks, which often have hidden assets:

1. Price-earnings ratios
2. Price-to-book-value ratios
3. Price-cash flow ratios

The best time to find hidden assets is when they’re still hidden, long before the company begins taking steps to profit from them. Understanding and seeking out hidden assets while you’re evaluating a stock can add enormously to your profits in the course of an investing career. But you need patience to profit from them, because they can stay hidden for a long time after you buy.

Hidden assets can also cut your risk. Stocks with hidden assets are likely to hold up better than those whose assets are easier to spot, since they are the last stocks that experienced, successful investors sell. When times are good, on the other hand, stocks with hidden assets tend to do better than average. Good times give them opportunities to put their hidden assets to work.

Q: What value stocks should investors stay away from?

Pat: Top value stocks may only be cheap due to hidden problems. I learned this lesson when one of my earliest value investments collapsed. It was cheap in relation to its asset value, but its asset value shrank drastically after it wrote down the value of its inventory.

My loss on the stock was big enough to hurt at the time. But it was a cheap way to learn a valuable lesson. It kept me from making far more expensive mistakes later on, when I had more money to invest.

If a stock seems like an exceptional bargain in relation to earnings or asset values, it may suffer from hidden risks. The stock can plunge when those problems begin to take their toll.

Have you learned the lesson of value investment collapse the hard way, too, and if so, what factors led to your loss?

What hidden assets do you look for in value stocks? What hidden problems would turn you away from a stock?