At a time when almost every stock is on sale, itís harder to sort out the real deals from the junk.
Value investing in a deep recession is a bit like trying to bargain hunt at a dollar store. At first blush youíre overwhelmed by the prices on just about everything. A value investor is, after all, drawn to beaten-down stocks trading at low prices relative to earnings.
But in todayís market, could you start randomly typing in ticker symbols and find shares that are cheap? That doesnít make them all good deals.
When shares of nearly every company in all sectors of the market are down sharply, as is the case today, you need to be more discerning about what makes a stock cheap. And to create an extra margin of safety, you should stick with ďcompanies where the probability of them going under is very small.Ē
Hereís how to go about it:
Comparison on P/Es.
At first glance, a stock might look cheap at a price/earnings ratio of, say, 11, which is below the marketís average of 13. But itís not that simple. Just as shoppers pay different prices for Italian wingtips and flip-flops, the market sets different valuations for different types of firms.
The only way to tell if a stock is really on sale is to compare its P/E with those of companies in the same industry.
Understand the business.
When you screen for companies with extremely low P/Es, youíll run into some risky shares. After all, if a stock is priced significantly below its peers, either something is wrong with the firm or investors think there is. Take the troubled insurer AIG (AIG, Fortune 500). It trades at a P/E of just 7, based on projected future earnings. But how confident are you that AIG will post profits this year?
This is why itís important to invest only in firms whose business models you fully understand, that writes off much of the financial sector, since no one seems to know all the counterparty risks banks and brokers are exposed to.
By contrast, you might consider a stock like Nike (NKE, Fortune 500) (see the chart above). Itís no secret how this firm makes money - shoes and apparel. And while itís threatened by the recession, Nike has a solid balance sheet, a powerful brand, and is making inroads into the lucrative Chinese market.
Avoid firms with big debts.
The father of value investing, Benjamin Graham, argued that financial troubles are often ďheralded by the presence of bank loans.Ē So he favored companies with low debt.
Graham, in particular, preferred companies in which working capital - defined as current (or liquid) assets minus current (or short-term) liabilities - exceeded long-term liabilities. In theory, those firms, which include companies like Nike and the oil driller Ensco International (ESV), have enough assets on their balance sheets to meet all their obligations.
At least make sure the company generates enough cash to pay off debts maturing in the next few years. Why? It used to be that firms could simply refinance when debts came due. But in this credit crunch, thatís no longer a given. You can look up on company cash-flow figures. But youíll have to look in the footnotes of corporate annual reports to find out how much debt is coming due soon.
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