Undervalued stocks may be an excellent choice for individuals looking to invest their excess cash in 2016. The year's opening has seen a sharp downdraft and increased volatility in the equity markets. Many analysts are noting the recent bull market has led to a lot of stocks trading at dangerously high valuations by the end of 2015, and many stocks that are overvalued may be in for some severe downside corrections. The situation has some investors shifting to a value investing focus, looking to reconstitute their portfolios with undervalued stocks. While value investing is often presented as an alternative to growth investing, undervalued securities frequently offer the potential for high percentage gains.
The Basics of Value Investing Principles
Value investing is a fairly straightforward investment strategy. Benjamin Graham is credited with popularizing value investing and setting forth many of the basic equity valuation criteria that value investors utilize to identify potentially undervalued stocks. The essence of value investing is the process of identifying companies that are fundamentally and financially sound, but whose stock is trading substantially below the genuine, intrinsic value of company shares.
Some novice investors make the mistake of thinking value investing is about buying cheap stocks, but this is not the case at all. In fact, one of Graham's basic principles in identifying undervalued equities is to only consider stocks that have at least an average quality rating. Many value investors only consider stocks that have a minimum Standard & Poor's earnings and dividend rating of B to B+ or better. Beyond just a ratings grade, investors are advised to look for companies with a fundamentally strong business model and an identifiable competitive edge in the marketplace. In short, value investors use basic company information to make simple, common sense judgments about the company's prospects of thriving in its given industry. Therefore, value investors consider the strength of company management, branding strength of the company's name or logo, or any proprietary products or technology the company possesses that provide it with a competitive edge.
Value investors avoid companies that are anything less than financially sound. This includes companies whose debt burden appears potentially problematic, which can be revealed by the debt-to-equity ratio. Generally, a company's debt-to-equity ratio should be no higher than 1.0, yet below the average for the company's industry. A zero debt-to-equity ratio means a company has little long-term debt. Value investors might also examine other common debt ratios, such as the debt-to-assets ratio or current ratio, but the driving consideration is always to identify companies with minimal debt, plenty of operating capital, and solid cash flow and profit margins that should enable it to weather temporary economic or industry downturns.
Another criteria used to identify good value stocks is to limit consideration to companies paying dividends. Sometimes strong, undervalued companies, particularly newer, smaller firms, simply have not yet reached the point where management feels comfortable returning profits to investors in the form of dividends. Again, each criteria or selection factor should be considered as part of the total picture of a company's financial health and industry position. Nonetheless, offering dividends is one more value point in a company's favor.
Price-to-Book and Price-to-Earnings Ratios
The price-to-book (P/B) ratio is a favored value investing metric. It compares a stock's market capitalization value to its book value. Value investors prefer to see a P/B ratio between 1.0 to 1.5 or lower, and more importantly, significantly below the average P/B ratio of a company's industry peers. The P/B ratio must be used with caution because, while a relatively low P/B ratio may indicate a stock is undervalued, it can also indicate a company is just fundamentally unsound.
Value investors also pay particular attention to a company's price-to-earnings (P/E) ratio, including both the standard, trailing P/E and the forward, projected P/E. The P/E ratio is a basic comparison of share price versus earnings per share (EPS). Additionally, the price/earnings-to-growth ratio (PEG) factors in a company's growth rate, share price and earnings. Generally speaking, a P/E lower than the industry or overall market average may indicate an undervalued stock. Graham's rule of thumb is to only consider companies with a P/E ratio of 9.0 or lower. In the market of 2016, with average S&P500 P/E ratios above 15, a single-digit P/E ratio certainly is one distinguishing factor for a stock. The P/E ratio is considered part of the basic importance that value investors place on a company showing strong earnings. Value investors prefer to see, at minimum, a solid five-year performance of EPS growth and no negative EPS numbers.