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One of my readers who is interested in learning more about the fundamentals of value investing emailed me the following question:

"I get the idea of buying undervalued stocks but how do you know if they are undervalued or just junk that you wouldn't want to invest in?"

This is one of the key questions that every value investor deals with. And investors approach this question in various ways. Every value investor wants a bargain, and every value investor says that they "buy $1 worth of assets for 50 cents" or other such language that has become ubiquitous nowadays. The question above is a good one. How do we filter out the garbage from the truly undervalued stocks?

First, Remember that Valuation is Most Important

I'll first say that it's most important to be fishing in cheap ponds. Although it's not popular and not necessary, it is possible (and profitable) at times to buy stocks of mediocre quality that are selling at prices that more than reflect the problems in the underlying business. Occasionally, these stocks are priced for less than the cash they have on their balance sheet. Some stocks occasionally are priced at what Ben Graham called "net-nets," or stocks that were selling for less than the value of their current assets less all liabilities. This is a quick and dirty measure to determine the stock's liquidation value.

Of course, a stock that is selling below liquidation value obviously would have some major underlying problems in the business. But Ben Graham made a living buying a basket of these net-nets and made 20% per year. Warren Buffett calls these stocks cigar butts - it's like finding a used cigar lying on the street with one or two puffs left. It's a nasty proposition, but the puffs are free for those who pick it up. Walter Schloss similarly made over 20% per year for nearly 50 years by simply buying cheap stocks.

(One note: Schloss was different from Graham in that he moved away from pure cigar butt stocks early in his career. Although he was famous for saying "We buy cheap stocks," if you look at the list of stocks his firm owned over the years, you'll see many stocks of quality companies. Schloss presumably preferred good businesses, but always focused on value first and foremost).

The Problem With Cigar Butts

There is a very important point to understand if you buy cheap stocks of mediocre businesses. Buffett is absolutely right when he says "Time is the friend of the wonderful business, and the enemy of the poor business." So it's easier to overpay for good businesses, but if you hold them long enough, you might be rewarded. Bad businesses on the other hand need to be sold upon appreciating to fair value, because bad businesses destroy value in the long run. So be careful if you buy cheap stocks of poor businesses, and be sure to own a diversified basket of them.

How to Determine Good from Poor Quality

Now, my own strategy revolves around identifying the cheapest 10-20% of the stock universe using a few common metrics like P/E, P/B, and EV/EBIT or FCF. Then, I try to find the highest-quality stocks within the cheap universe. This is similar to Joel Greenblatt's famous "Magic Formula."

I have lists of the cheapest stocks, and that narrows down my focus area. I know that by focusing my efforts on stocks that are cheap, I have a built in safety measure. If I make an error in judgment, at least I'm doing so in the cheap, and not expensive, part of the stock universe.

Okay, so it's easy to determine which stocks are cheap. Just use a screener and filter out the stocks you want to look at. So how do we determine which stocks have quality and which ones are junk?

Buffett is famous for saying he likes the companies he holds to possess a durable competitive advantage. He determines this in a number of ways, but here are a few things I look for in my initial glance at a company's income and balance sheet:

  • What is the debt-to-equity ratio? I check the balance sheet first. Debt isn't always bad, but if the stock is cheap, it usually has some problems. Debt can exacerbate those problems.
  • What is the company's return on capital? I look at ROC and ROE to determine quality. Consistent high returns without using much leverage (debt) indicates a durable competitive advantage.
  • What does 10-year book value growth look like? Some investors don't look at this, but book value growth is one of my favorite measures to look at. A company that is steadily growing its net worth over time must be doing something right. It doesn't necessarily indicate a competitive advantage, but it's certainly a positive sign of quality.
  • What does 10-year free cash flow look like? I like to find companies with 10 consecutive years of positive free cash flow. This is rare, and not always necessary, but it's a good sign when you find it.
  • What does 10-year sales growth look like? I use Morningstar or Value Line to glance at 10-15 years worth of sales history. A steady growth of sales is a good sign.
  • What is the gross profit margin? Buffett says that a company with consistent 40%+ gross margins likely has a competitive advantage.

So those are some quick ways to determine from the numbers if a cheap stock you're looking at might be a good company. I use Morningstar and Value Line to simply glance at these numbers. When I see something interesting, I begin more detailed research, which includes reading the company's annual report. But to initially filter a large list down to a small number of candidates to perform more detailed research is key. Identifying the numbers for the above six categories can eliminate many of the value traps that exist in the cheap universe.

Here are a few examples of stocks that meet most of the above characteristics (it's rare that a cheap stock meets all of them). I'll just show the basic data from the income statement and balance sheet:

EZ Corp (EZPW)

EZPW is a pawn shop operator selling for just 7 times earnings and 1.1 times book value. The business is somewhat boring and basic, and there are certainly (as usual) things to be concerned about. But look at the numbers:

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By just looking at the numbers, it appears to have some quality metrics with outstanding consistent gross margins (averaging about 60%), growing book value ($2 to $16 over the past 10 years), 10 straight years of free cash flow, and solid returns on capital and equity. Might be worth further research...

Kohl's (KSS)

KSS is a retailer that is selling for 11 times earnings and 1.7 times book value. The stock has struggled this year, hovering just above it's 52-week low. Is it undervalued or a value trap?

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The company may or may not have a durable competitive advantage, but it certainly has some quality characteristics. Sales have nearly doubled in the past 10 years, along with net income. The company has produced positive free cash flow in 8 of the past 10 years, allowing it to significantly reduce the number of outstanding shares. Buybacks are another thing I like to see. They have helped the stock's book value grow by 150% over the past 10 years. Book value growth usually leads to stock price growth over time.

The company's returns are not outstanding, but they are consistent. It has a debt/equity ratio of .7, which is slightly higher than I'd prefer, but strong free cash flow and a solid cash position gives KSS the option to pay down debt as well as continue to buy back shares. The debt/equity ratio is still below 1, which is a level that begins to become a warning sign.

Intel (INTC)

Intel is a large-cap stock that most everyone is familiar with. This former high-flying tech stock is now viewed as old and mundane, and it's been slapped with a low P/E ratio of 10, but take a look at the numbers:

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INTC is cheap, but it also looks like a high-quality company. Consistent gross margins above 50%, 10 straight years of positive free cash flow, steady growth of sales and book value, and a clean balance sheet with enough cash to cover its small amount of debt. I noticed this stock using the Magic Formula screen, and the returns on capital are very high for a stock that sells for less than 10 times free cash flow. Plus, the stock sports a 4% dividend at the current price.

Guess (GES)

GES is another retailer whose stock has spent much of the past year near its 52-week low. It's cheap relative to earnings at a P/E of 11, and take a look at the numbers to determine its quality:

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GES looks like a high-quality company with 10 years of consecutive free cash flow. In the past decade, GES sales have gone up 4-fold, book value has risen 5-fold, gross margins are steady near 40%, and although returns on capital have dropped in the past year, they've been historically above average during the course of the past 10 years. Plus, the company has $3 per share of cash and no debt.

Hopefully these four stocks provide some examples for you to study when trying to filter out the good stocks within the cheap universe. Some screeners (like Greenblatt's Magic Formula) do this work for you, and so those are good places to find ideas, but it helps to understand what metrics are important when identifying quality from junk.

Source: How To Determine Good Vs. Poor Quality Within The Value Universe