The Perfect Value Stock - Value Stock Guide

perfect How do you find the perfect value stock?

Sometimes, if you are patient enough, the stars align and all the necessary conditions coalesce, offering up a perfect value stock to investors meticulously scanning the landscape.

Value investing was born in the 1920s, pioneered by Benjamin Graham and David Dodd at a time when stock investing was mostly fueled by speculation and a sprinkling of insider information (learn how much value you should place on insider buying stocks). Value investing represented a break from that school of thought, towards a more rational examination of the drivers of value within a business. Naturally, this led to reasoned and careful stock analysis, scrutinizing companies using fundamentals such as book value, earnings, and cash flow.

The Tripod: Valuation, Business Acumen, and the Economy

That is just one leg of the value investing tripod. As an investor, you want to make sure that the company you are buying is worthy of investment. Not only that, but the business has to be selling at a significant discount to intrinsic value to provide enough margin of safety. The greater the margin of safety, the greater the room for error. Valuation is an art and a science and all value investors invest knowing that their estimate of intrinsic value may be slightly off base in either direction.

The second leg is activity within the economic cycle. An economic downturn can be a perfect time for value investors to go shopping because shares tend to be priced lower. When the economy is chugging along, investors and speculators alike jump on the stock market bandwagon, driving prices higher and higher. It can be devilishly difficult to find undervalued stocks in such an environment. When the economy is in a recession it becomes far easier to find underpriced shares. Just as bandwagoners jumped on when the going was good, they tend to jump off en-masse as things start to turn sour. This drives prices down, and below fundamental value.

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The third and final leg has to do with the business itself. The perfect value stock shows itself when security valuation, business positioning, and the economic cycle all work in tandem to provide the best platform for a value investor.

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The economist Joseph Schumpeter coined the term “creative destruction,” which refers to the continual process of innovation and renewal wherein new businesses replace old businesses. This typically happens during recessions, when companies go bankrupt, and their factors of production end up in the hands of new firms.

Read: How to be a successful value investor

It’s not enough to simply get your wallet out during a recession and buy companies that are marked 50% off. You need to have a process. You need to find a company that isn’t just cheap but is also well-placed and making the right moves to come out of the recession stronger than before. You will have your work cut out for you because only 9% of businesses outperform themselves and their rivals following an economic slowdown.

[Read: Cyclical Investing]

It turns out that the advice for finding these companies is somewhat counterintuitive. The enterprises that were the first to cut costs or the ones to cut the most were not the ones that thrived. Instead, the eventual winners got where they were by improving on operational efficiency as well as investing in R&D, marketing, or additional factors of production such as plants and equipment. Thinking about it, it makes sense that this strategy would work. It would seem that for businesses in a recession, the best defense is a good offense. Instead of drastic austerity measures, companies are better served by investing in themselves when everyone else is losing their heads. It helps if you have the money to do so, of course, but the research backs this up. Look for companies that are using their money wisely, investing in new assets and getting ready to increase production so that weaker competitors are ushered to an early death. By the time everyone emerges from the recession, these offensively-minded companies are well-positioned to grab increased market share and additional pricing power.

Harvard Business Review warns against being too gung-ho, however. The companies that did the best implemented a mix of defensive and offensive tactics – combining investment and cost-cutting. In their research they classified companies into four types

Prevention-focused companies: these companies were primarily defensive, concerned about limiting losses
Promotion-focused companies: more concerned with offensive moves
Pragmatic companies: mix of defensive and offensive
Progressive: employed an optimal combination of defense and offense

The progressive group had the highest probability of outperforming post-recession, compared to the other groups. They increased operational efficiency rather than engage in mass-layoffs, only a quarter of progressive companies reduced head counts versus half of all prevention-focused companies. They also made larger investments in capital goods, marketing, and R&D than their peers.

The stories of Office Depot and Staples during the 2000 recession contrast the different approaches. Office Depot was more defensive, cutting 6% of their staff without making a dent in operational efficiency. Staples ended up increasing its workforce by 10% to support a new line of premium products and services. Operational costs were kept reined in, and the company emerged from the recession healthier than when they went in.

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The perfect trifecta for value investors should be the confluence of valuation, positioning in the economic cycle and the operational moves the business is making. When all of these line up a value investor can invest knowing that he is giving himself the best chance at success.