A+ or F? What Makes for a Good Value Stock Pick...

By Chris Gallant | January 17, 2006 AAA

The stock market has seen its fair share of fortunes built from keen value investors who make timely purchases of undervalued stocks. Entire companies, such as Warren Buffett's Berkshire Hathaway (BRK.A), have been fueled by such successful value plays. Buffett's major investment in American Express (AXP), made at time in the 1960s when the salad oil scandal was spiraling AXP shares down to extreme lows, catapulted his company and shareholders on to great successes.

It comes as no surprise then that scores of investors seek to replicate those successes by hunting for the next undervalued stock destined to turn around and beat the market in the long run. Probably more than a few of these "value investors" had their interest piqued when troubled auto manufacturer Ford Motor Corporation's (F) CEO, William Clay Ford, Jr. detailed his outlook for the company's turnaround prospects in a recent interview with Business Week.

But what makes a stock a good value play? Obviously, one of the first things most investors look for is a low share price, P/E ratio or similar metric compared to the company's historical range. Taking a quick look at Ford's price performance over the last five years, we see it's settling down into a long-term low.

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If one wants to follow Buffett's strategy of buying at low, undervalued prices, we can see that Ford is currently giving us a price not seen in five years. In fact, the company's stock is dangerously close to hitting a 20-year low. Looks like a good opportunity, right? The only trouble is, simply comparing a company's current price to historic valuations doesn't tell us the whole story.

In fact, for an investment in F shares to become an A+ for our portfolio, the company will need to overcome some serious challenges before it has a chance of winning back the market's affection. For starters, growth in auto sales would be nice to see. And I'm not talking about stratospheric growth on par with the likes of Google (GOOG) or Yahoo! (YHOO), I'm only asking for positive growth. I say this because, as of their last 10-K filing, Ford was able to ring in a total of 17.3 million automobile sales in 2004, about 500,000 less than the 17.8 million sales they registered way back in 2000.

On top this, as a company Ford has been suffered a net operating loss from their automotive production unit for every single year since 2001. And yes, industry conditions are part of the problem, but competitors like Toyota Motor (TM) have been able to steadily increase their operating profits during this time.

Meanwhile, Ford's financing division has been the only thing keeping it in the black the last few years, and trying to improve the company's automotive division seems like an almost impossible task. Recent attempts such as offering employee-only prices to all consumers, a strategy also employed by troubled automaker General Motors Corporation (GM), have cleared out some surplus inventory but done little to improve bottom line profits.

Analysis of why this discrepancy of performance exists between Ford and its competitors could easily turn into a full-blown report, but at the end of the day the bottom line is rather simple. As an auto company, Ford can't compete well enough in its market to provide a good expected return for its stockholders.

It quickly becomes obvious to us as investors that the odds of a near-term Ford comeback are pretty slim, and we begin to the realize that the old "turn-arounds seldom turn" cliché popularized by guys like Warren Buffett is a cliché for a reason – it's true. Even though Ford's trading at very low historical levels, it might still be overpriced.

When it comes to making value stock picks, simply buying up stocks that are trading low prices, P/E ratios or similar metrics just isn't going to cut it. Successful value investors are able to pick out stocks that are not only cheap, but also belong to good companies that will generate reasonable growth over time. This isn't easy, but it can be done, and a big part of the Investopedia Advisor's investment philosophy involves doing just that.

One of our Core Holdings, Iron Mountain, Inc (IRM), is a prime example – the company consistently produces strong, recurring revenues, enjoys a wide economic moat and significant pricing power in its market. Since our selection of IRM for our portfolio this past July, the stock has appreciated over 35%, and that return sure is much more of an A+ for our portfolio than an investment in F shares would have been.

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