How To Pick Value Stocks

by: Evan Bleker

Summary

If you're a value investor but not beating the market, you're probably making a major strategic error.

A lot of investors just try to copy Warren Buffett or select well-known large cap companies. This is a mistake.

By using a mechanical investment strategy made up of micro cap stocks, you can greatly improve your portfolio performance versus the market.

I find it ironic that more research is being done today than at any point in time in the past, yet a lot of value investors are failing to beat the market.

Ironically, the mountain of articles on popular investing websites just aren't helping. Part of the problem might be due to the "more brains" problem Graham cited years ago. Since everybody on Wall Street is so smart, all those brains ultimately cancel each other out.

This glut of brain power, investment research, and investors clamoring for bargains does not mean that you can't beat the market. But, knowing how to pick value stocks is a key requirement, along with having a good strategy and being prepared to do things that most other investors aren't.

Where You Should Hunt When Picking Value Stocks

One core piece of the puzzle is leveraging your biggest competitive advantage as a small investor: your size. Let me explain...

Professional money managers manage billions of dollars each year. In fact, the entire mutual fund industry in the USD in 2012 amounted to $13 Trillion and the size of the average mutual fund was a staggering $1.72 Billion.

Legal regulations make owning more than 10% of a single company, or having a single company make up more than 5% of assets, a real burden for a fund company. Given that managers want to keep positions below 5% of their fund, the pool of investment candidates open to money managers is tiny. These restrictions essentially limit a manager's universe of stocks to firms that are $860 Million in market cap or larger. That means focusing on roughly 500-600 of the largest companies in the US.

With that much money sloshing around the markets, small, medium, and large cap companies are, understandably, extremely picked-over. This suggests a powerful advantage that small investors can leverage: investing where the pros aren't investing.

That really comes down to investing in micro cap and nano cap companies. It's in this universe, among the thousands of tiny publicly traded companies available, that a small investor can pick the most promising value stocks.

What Value Stocks to Concentrate On

15 years of experience in investing has taught me a few very valuable lessons.

The first is that, despite your research, you're probably not as important to the end result as you'd like to think you are. Sure, you can conduct an analysis and your stock can go up just as you predicted, but it may not have advanced for the reasons you thought. Sometimes the stocks that you assume that will work out well... don't. And, at other times, the stocks you thought were real dogs will advance in price.

Another core insight I've had over the previous decade is that I (and likely you, as well) am not Warren Buffett. Small investors can't bring the same amount of skill and experience to investing as he does, and blindly following how he invests today is what I call falling into the Warren Buffett trap.

Luckily, a small investor doesn't have to have Buffett's investing prowess to know how to pick value stocks and succeed as an investor. Investing is a probabilistic exercise, and I've found leveraging a statistical investment strategy (i.e. "Mechanical" investing style), extremely rewarding. Leveraging them means being able to earn the same investment returns that drew you to value investing in the first place... without you having to be an investing guru.

By simply buying a basket of stocks that are undervalued relative to some value metric, you can leverage those statistical returns to propel your portfolio to large profits.

What Sorts of Strategies am I Talking About?

The sorts of strategies that I'm talking about fall into the "classic value investing" or "deep value investing" categories. These are the value strategies that Benjamin Graham talked about years ago when he taught his students how to pick value stocks. These strategies have been extensively tested, and used successfully in practice for decades.

Low PE - One of these strategies is the classic Low Price to Earnings strategy. This strategy has been employed successfully by contrarian managers such as David Dreman, whose funds returned 16-17% per year over decades. In general, as reported by Tweedy Browne, a Low PE strategy is good for an average annual return of 16%.

Low PB - Low Price to Book value is another classic value metric that yields market beating results. Using the strategy investors should expect to bag a CAGR as high as 14.5%. That's a fat 45% in excess of the market return over the course of your life.

Low PC - One of the more recent classic value strategies, and focuses on finding stocks low relative to Cash Flow. This strategy performs a bit better, recording a CAGR of just over 18%.

High Dividend Yield - Mario Levis at the University of Bath conducted a study called, "Stock Market Anomalies: A Reassessment Based on the UK Evidence." He found that the highest dividend yielding stocks returned 19.3% on average. Not bad for a basket of cheap stocks!

Net Nets - But the king of these strategies is Ben Graham's famous net net stock strategy. This strategy has consistently beaten the market both in studies and in practice by roughly 15% per year. That amounts to a 25% CAGR, and you can achieve even higher returns with a basket of net nets by screening for other key characteristics. And, my own portfolio has done very well using this strategy.

Of course, the catch is that while you can always find enough stocks to fill a portfolio using the first 4 strategies, during bull markets domestic net nets dry up, making it almost impossible to use the strategy. At least, that's what popular websites will tell you -- which tripped me up years ago. By expanding your universe of investment candidates to include friendly international markets you can fill your net net stock portfolio under all market conditions.

How to Pick Value Stocks Once You've Nailed Down a Core Strategy

This is where hunting for tiny stocks comes into play. When picking value stocks, you're going to find your best opportunities within the universe of small companies.

I'm going to come at this from the perspective of a net net stock investor, since this is where I've chosen to specialize. That being said, the process is the same for any statistical value strategy.

As it turns out, not only do small stocks offer the best opportunities for value investors, but statistical portfolios of the smallest value stocks also offer the best portfolio returns. When it comes to net net stocks, Xiao & Arnold found that a portfolio of the smallest net nets returned significantly more than the largest net nets studied, 30.6% per year vs. 17.2% per year. That's a staggering difference in return.

The same trend is found among other sorts of classic value stocks. Tweedy, Browne found that the smallest 1/5th of Low PE stocks outperformed the largest, 19.1% to 13.1%. So, no matter what strategy you use, go small. Go tiny, in fact.

This is where major investing websites really start to trip up investors. The focus on large investing sites is almost always on large stocks, and that causes small investors to give up a much more promising universe of investment opportunities in favor of trying to compete against the pros. Plus, you can only take advantage of a net net stock strategy if you're buying tiny companies.

Once I've narrowed down my list of possible investment candidates to the smallest, I like to look for additional metrics that are highly correlated to outperformance versus the benchmark. For net nets, one of those characteristics is a Debt to Equity figure below 20%. Companies with low Debt to Equity ratios drastically outperformed the benchmark in Tweedy, Browne's study, What Has Worked In Investing, recording a CAGR of nearly 35% compared to their universe of net nets which returned 28.8%. That's 6% per year of extra return!

I also avoid firms with major Chinese operations, due to the flood of reverse merger scams, as well as resource exploration companies, pharmaceutical companies, real estate companies, and companies in regulated industries such as finance. None of these make for the highest quality net nets, and I'm after the highest possible returns. In the end, you have to stick to the most promising industries, and this usually means focusing on your domain of competence.

How to Craft Your Portfolio

If you do a good enough job using additional criteria to screen out the less promising candidates, building a portfolio really takes care of itself.

At the end of the process you should be left with a very manageable number of firms. From there, spend time ranking the firms from most to least promising and then spend an equal dollar amount on the 20 most promising investments. That's it.

....sort of. There are also nuances in portfolio construction and management that can really impact your returns, but that's not the focus of this article. I'll write that article at some point in the future. By now, you should have a great idea of how to pick value stocks for your own portfolio.

Investing is really not as difficult as you think it is but, ironically, a lot of people try to make it more difficult than it needs to be. The hardest part is really sourcing the investment ideas and then narrowing down the pool of investment candidates you pick from. At Net Net Hunter, we start with over 450 statistical international net nets but then narrow the pool down to the 30 most promising, which gives you some idea of the amount of work to do if you want to buy the best investment opportunities.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.