HOW TO PICK VALUE-BASED STOCKS THAT CAN MAKE YOU WEALTHY
Value investing is one of the best-known stock-picking approaches. The generally accepted foundation of the approach was established in the 1930s by Benjamin Graham and David Dodd, finance professors at Columbia University. Inspired by the market crash of 1929 and the subsequent Great Depression, Graham and Dodd advocated buying the stock of companies when they are selling at a deep discount to their inherent worth.
Authoring the famous book, The Intelligent Investor, Graham and Dodd recommended that investors size up companies based on
fundamentals,
including price-to-earnings ratios, dividends, book value, and cash flow. Next, they advise
purchasing
stocks when the company's stock price
provides
a significant discount to the company's inherent value.
Value investors seek to buy a stock when the price is incorrectly valued (undervalued) with the potential for a significant increase in share price when the market corrects the error in valuation. KEY VALUE-based stock SELECTION FACTORS
1) Value Investors don't buy a stock just because it seems cheap. Value Investors buy the stock of quality companies when something has caused the price of the stock to be incorrectly valued. These incorrect values can be caused by any number of things, with the primary reason for a drop in price being simple fear.
The most obvious, recent example of company shares being incorrectly priced as a result of fear was the big selloff of the equity market in late 2008/early 2009. At that time, many investors were concerned that the financial world was about to collapse, and the price of the stock of many high-quality companies, such as Apple Inc., dropped to incredibly low levels when compared to the company's intrinsic value.
2) Value Investing doesn't mean buying junk (or "Cigar Butts," as Warren Buffett calls them), it means buying the stock of quality companies when their share price is below their intrinsic value as established by their current fundamentals when compared to the universe of stocks.
3) Value Investors see the stock of a company as a vehicle by which a person becomes a partial owner of the company. Since Value Investors see themselves as partial owners of the company, they don't trade a company's stock.
Because the Value Investing approach is about determining the worth of the underlying asset, value investors ignore the short-term external factors affecting the stock, such as volatility or day-to-day price fluctuations. These issues are not inherent to the company, so they have no affect on the value of the business over long-term.
Since the 2008 market crash, the prices of most individual stocks have moved in correlation with the broad market. In fact, almost all asset classes have moved in correlation with headline (news) events since the middle of 2008. This includes stocks, bonds, energy, gold, etc. It has been almost impossible to escape negative news events no matter where investors placed their money, including deeply undervalued stocks.
Because of this high correlation of assets along with high sensitivity to news events, we felt we had to move IntelligentValue's stock picks more toward technical investing rather than value-oriented picks. I believe that now may be the time for value-based stocks to move back to the forefront.
4) Patience Required: Historically, to implement the Value-Oriented approach, investors would buy a group of stocks with the fundamental criteria I'll list in a moment. Then, value-oriented investors would
(typically)
wait over longer time horizons for their stock to realize the intrinsic value that they believed was present.
However, value-oriented investors have always been at risk of falling into a 'value trap.' Stocks with low Price-to-Value ratios can be either a great opportunity or a bankruptcy waiting to happen. Determining the future prospects of undervalued companies is the challenge that Value Investors must face with every stock purchase.
However, we feel the market may have reached a turning point relative to the high correlation of investment options. When investors and Wall Street traders come back to Wall Street, it's likely that we'll see a strong move of the market is objective sure to get working recorded: going back to you. They should fix that should not mean working out yellow, go Leah – you start answering. So if youin one direction or the other. A strong selloff will provide value investors (including us) with lower entry prices over the next few weeks, while a strong move upward could mean that we're 'off to the races,' so to speak, with a sharply higher market. Either way, we will be looking for the stock of companies selling at a discount to the company's intrinsic value.
SPEEDING UP THE TYPICAL LONG-HOLD TIME FOR VALUE STOCKS
5) As a solution to the long time horizon typically required for value investing, IntelligentValue adds additional elements to classic Value Investing to find stocks that will produce excellent returns in JUST 30-45 days: In each of our Ranking and Stock Selection Systems, we've added a Momentum Element and a Market Timing Element.
In our exhaustive backtesting of hundreds of stock factors and formulas, we've learned that stocks with upward momentum in their moving averages, and/or relative strength when compared to a market benchmark, can dramatically increase the returns from a value-oriented portfolio and help to ensure that other investors have began to see the same values that we are seeing, bidding the stock price higher. Including momentum in our factors also helps to prevent us from buying a stock that is a 'Value Trap,' i.e., a 'cheap' stock with a price that just continues to head lower, potentially to zero (consider RIMM as a possible example).
6) To accompany the Value and Momentum elements, we usually require that the broad stock market is also moving higher when we make purchases. When the market is moving down, 70% to 80% of all individual stocks move along in correlation with the market. Although it's extremely difficult to identify exact market timing points down to the day, we can usually identify periods of market headwinds and market tailwinds. This is the essence of what we call "Dynamic Value Investing."
To see the status of our Market Timing Dates, subscribers can bookmark this page. If you're not yet a subscriber, you can get instant access right now. Market Timing charts/dates are updated each weekend, as well as whenever there is a change in the status of the Daily Signals during the week. Subscribers are also notified in a midweek Action Alert when there's a change of status.
Buying stocks when we have tailwinds from behind and the broad market is moving higher, as well as making sure each individual stock pick has positive momentum significantly increases our chances of profiting from our undervalued stock picks.
A Portfolio Based on This Ranking System is Extraordinary. The chart below shows the performance of this system over the last year:
A portfolio based on the DVR 6-Factor System is amazing. Chart courtesy of Portfolio123.com.
In backtesting, this portfolio produces an annual return of 302% with a maximum drawdown of 24%. Overall winners were 75% of the portfolio and the Sharpe Ratio is an astonishing 6.54. The average stock was held 47.27 days with the biggest winner gaining 119.35% and the biggest loser at -26.90%.
However, consider the results when our Intelligent Market Timing System is applied to this portfolio:
The Results Are Astonishing. When these timing inputs, either long in stocks after Market Up signals or in cash after Market Down signals, are used in the value-based stock-selection system discussed above, the drawdown is halved. That's excellent news!
However, when drawdown (some call this risk) is reduced, the result is usually lower overall returns. 'No pain, no gain' as they say. So how much are returns lowered? None. Zip. Squat. Nada.
In fact, at the time of this writing, backtested returns are increased to 702% annually! In more than 35 years, it's one of the few times we've seen risk reduced and reward increased in an investment context. It's never occurred at this level, with nearly doubling the original backtested results.
When applying the "Intelligent Timing" system to this portfolio in the market rally from April 2009 to April 2010, the annualized return jumps to +702% while the drawdown was reduced to just -11.8%. Overall winners were 80% of the portfolio with the highest gain being 125%. The average hold time was 47 days, and the Sharpe Ratio is a whopping 13.3 - the highest I have ever seen! Here's a chart of one year through the end of April, 2010:
 Double the return with half the drawdown when using the 'Intelligent Timing' system. Past performance and/or backtested results are not indicative of future returns. Model portfolios are for educational purposes only. IntelligentValue does not handle client's funds. Chart courtesy of Portfolio123.com.
value-based factors and formulas that work
Over the last decade, we have spent thousands of man-hours running many hundreds of back tests (in the Internet cloud) carefully evaluating individual stock factors and formulas to determine which ones are most indicative of a stock's future performance.
After identifying the top factors and formulas, we ran many hundreds of back tests to determine which combination of factors and formulas provided the highest portfolio returns. We've discovered that the following factors and formulas produce the highest, most robust returns over different time periods:
 Price/Sales Ratio - This is the number one value-oriented stock selection factor, according to our very robust backtesting. I also note that
James O'Shaughnessy, author of several respected investment books based on backtesting performed on the huge Standard and Poors stock database also came to the conclusion that the P/S ratio provides the best performance of any stock-selection ratio.
Price/Book Ratio - The second-best ratio is the P/B ratio, which compares the stock price to the assets and cash from the company being examined. This is one of the fundamentals of value investing: if all else fails and the sales were to start tomorrow, what would an investor in the company be left with but the building, equipment, cash and other balance-sheet assets.
PEG Ratio – Although the P/E ratio shows very poor performance as a stock selection tool (contrary to what almost every amateur 'value investor' believes), the P/E ratio divided by earnings growth is a solid indicator of future stock price performance.
Price/Cash Flow - Cash flow is what it's all about. You can have the most incredible sales and even incredible earnings shown on the books, but if you don't have cash flow to back it up, the stock is worthless.
Free Cash Flow-to-Assets and Market Capitalization - Again, Cash Flow is critical, but this time are using the Free Cash Flow compared to the assets and market capitalization of the company.
Price-to-Free Cash Flow - Free Cash Flow is the magic elixir – more powerful than simple Cash Flow. We examine Free Cash Flow per share compared to the stock price as another, very powerful component of selecting stocks based on value. Click here to read the definitions and differences between Cash Flow and Free Cash Flow.
Additional Important Factors in Today's Market Environment:
This past week we consolidated our Aggressive portfolio into the Premier Value portfolio, returning to the single portfolio that served so well when we originally launched IntelligentValue.com. As of this week and the start of 2012, we have returned to that single portfolio, which we believe will better satisfy subscribers, providing ease of use and diversification.
Going forward, two of the key considerations that will be applied into our stock selections system include the following factors:
Dividend Yield
5-Year Dividend Growth Rate
We believe that dividend yield and dividend growth rate will continue to be very important aspects of stock selection as the current macro investment environment remains uncertain. Although individual company fundamentals may be quite good, the overall market is being driven by what governments do. That means a great deal of uncertainty and perhaps a flat market. Dividends improve overall performance, especially if they are re-invested back into the stock holding.
The best way to approach this challenging investment environment is to return to the original approach of value investing, i.e., focus on good companies with solid fundamentals and ignore the day-to-day fluctuations based on rumor, speculation, and government announcements.
In this environment, DIVIDENDS can provide a very important contribution to overall returns, frequently doubling overall annual stock returns.
CURRENT
RECOMMENDATIONS
As discussed earlier, we will look to our Intelligent Timing Model to tell us when to go partially long the market, 100% long the market, or 0% long the market, i.e., in money market funds.
Currently, there is a weak MARKET UP signal on the Short-Term (Daily) Timing Chart, while there is a MARKET DOWN signal from the Medium-Term (Weekly) Timing Chart.
The Long-Term (Monthly) Indicator is sending a mixed (sideways) signal, so that none of the charts are in sync with each other. This makes for a very unpredictable market situation on Tuesday morning when all the traders come back to their desks on Wall Street.
Because the market direction is too difficult to predict in the short term, I'm extremely hesitant to commit significant money to stocks, no matter how undervalued they appear. As mentioned previously, the market moving lower will provide us with a better entry price, while the market taking off could be the start of a solid rally and we'll want to pounce. It's not whether we'll buy undervalued stocks, a matter of when we'll buy them.
There will be time to make an accurate call when we see how the market breaks from the ever-tightening wedge pattern it has been in since the selloff in August. As you can see from the chart of the S&P 500 index below, prices moved to just above the upper wedge line, but have yet to provide a significant MARKET UP signal:
When there is a break in the market in either direction an Action Alert will be issued with new stock picks.
We will leave the Premier Value Portfolio as is, with a small position in SSO, the ProShares 2 X long ETF based on the S&P 500. I am comfortable with the stop price at $43.
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