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If you love money and personal finance, you may have heard of value investing. Better known as Warren Buffett’s investment philosophy, it has enriched many investors over the years. Studies show that value investing tends to outperform growth strategies over the long term. By emphasizing overlooked stocks and long holding periods, value investing spares investors the risks of bubble stocks and the costs of day trading.
So, value investing is a good strategy. The question is, if it’s so good, why isn’t everyone doing it? The principle of “buying stocks low” seems simple; shouldn’t everyone immediately practice until there are no more cheap stocks?
Theoretically, yes, which brings us to the main drawback of value investing: the difficulty of finding genuinely cheap stocks. In order to say with certainty that a stock is “cheap”, you need to know not only that it is cheap relative to last year’s earnings and assets, but also relative to next year’s earnings. . It’s that last part that trips up a lot of people. Sometimes stocks that seem “cheap” simply go bankrupt. To be successful in value investing, you need to find stocks that are both cheap and high quality. In this article, I will show how this is done.
Step 1: Use a stock filter
The first step to finding cheap stocks is to use a stock screener – a tool that allows you to narrow down a large list of stocks to a small one. The selection criteria you would want to use for a value screen would include
- A price/earnings ratio (P/E): a ratio of a stock’s price to the profit made by the company. Aim for P/E ratios below 20;
- A price-to-book ratio: a ratio of the share price to the company’s assets, less debt. Aim for less than two; and
- a price to free cash flow ratio: a ratio of the share price to the cash produced by a company after all expenses and borrowings, without paying attention to non-cash costs. Aim for less than 20.
You can add other ratios in addition to those mentioned above. The goal is to filter the universe of stocks for names that are priced low relative to the underlying company.
Step #2: Check the financial statements
Once you have a list of stocks in place, it’s time to check their financial statements. For example, income statement, balance sheet, etc. These will help you determine if a cheap stock is really a “bargain” or just poor quality.
If you look at a stock like SNC Lavalin (TSX:SNC) for example, you’ll think it looks cheap at first glance. But when you look at its financials, you’ll start to see red flags. For instance:
- The growth of its turnover is only 4%
- Its net profit collapsed in the last quarter
- Its day-to-day operations spend more money than they bring in
- The company still lists “litigation settlements” (e.g. having to pay people who sued them) as a risk factor
SNC-Lavalin has been a controversial company for much of its history. He has been involved in numerous scandals, including one involving the corruption of African governments. That’s not to say it’s not a profitable investment, but it does show that stocks aren’t cheap for no reason. Sometimes there is ugliness beneath the surface.
Step 3: Check everything
Last but not least, after finding a list of valuable stocks and checking their financials, you’ll want to double-check your work. Make sure you don’t forget anything in your analysis or forget to read a key financial statement. Value investing is all about safety, and you can’t be safe until you consider all of the possible risks of an investment.