A stock that tends to trade at a lower price relative to it’s fundamentals (i.e. dividends, earnings, sales, etc.) and thus considered undervalued by a value investor. Common characteristics of such stocks include a high dividend yield, low price-to-book ratio and/or low price-to-earnings ratio.

A value investor believes that the market isn’t always efficient and that it’s possible to find companies trading for less than they are worth. An easy way to attempt to find value stocks is to use the “Dogs of the Dow” investing strategy – buying of the 10 highest dividend-yielding stocks on the Dow Jones at the beginning of each year and adjusting it every year thereafter.

Investing in value stocks is not just investing in cheap stocks. Good value stocks pay dividends and/or have high growth potential. These stocks commonly have a very sound business plan and return profits year after year. When there is a market rally value stocks often get left behind as investors follow rapidly growing stocks. However, when the rally corrects or the market reverses value stocks do, in fact, retain their value. Value stocks tend to outperform the overall market over the long term.

Picking Value Stocks

Investing in value stocks requires that you pay attention to the market. Using stock screens to find low profit to earnings ratio stocks is useful. However, investing in value stocks also requires that you understand just how it is that a company makes its money and how it will continue to do so.  Often times this requires an outside the box view of stocks and the market in order to understand how global events and other factors will tend to drive stock prices in the near and midterm future. Forbes provides an example of how to do this in their article about the top ten value stocks that they see in emerging markets.

A weak recovery in the U.S. and Europe has helped reduce the price to earnings ratios on a number of large cap stocks in the big emerging markets. Value investors take notice. Here are the top 10 recommendations by stock forecasters at ValuEngine.com.

Examples given include AsiaInfo Linkage (ASIA) which is referred to as the backbone of China’s mobile telecom system. A second stock mentioned is the Brazil petroleum giant, Petrobas. And a third is Brasil Foods, the largest food company in Brazil. Each of the ten suggestions in the article is a solid company that is situated in a country with economic issues. The working assumption is that economies will recover and investing in value stocks in Brazil, China, India, etc. will be profitable in the long term as you are picking up deals on what in the long run will be cash cows.

The Energy Sector

How long will the price of oil stay down? That will be how long energy stocks will remain in the doldrums. Supply has outstripped demand and when producers cut back and the economies in China, Japan and Europe pick up steam oil prices will go up. The New York Times suggests that there is value after a plunge in the energy sector and that several hedge funds are positioning themselves to take advantage.

While many investors, including Warren E. Buffett, were selling energy stocks in the final three months of 2014, several hedge funds sought to profit on the turmoil, regulatory filings showed on Tuesday. Third Point, the firm run by Daniel S. Loeb, acquired a sizable stake in the oil refinery company Phillips 66, while Leon G. Cooperman’s Omega Advisors amassed a new position in Laredo Petroleum, and Viking Global Investors, led by Andreas Halvorsen, increased its stake in Cheniere Energy by several million shares.

Although hedge funds tend to jump in and out of stocks, long term investors may find opportunities for investing in value stocks that they can buy cheap today and hold forever.

Investing in Value Stocks DOC

Investing in Value Stocks PDF

Investing in Value Stocks PPT

More Resources

What Is the Schiller P/E?

P/E ratio stands for price to earnings ratio. Investopedia says:

P/E is short for the ratio of a company’s share price to its per-share earnings. As the name implies, to calculate the P/E, you simply take the current stock price of a company and divide by its earnings per share (EPS):

P/E Ratio =    Market Value per Share / Earnings per Share (EPS)

Most of the time, the P/E is calculated using EPS from the last four quarters. This is also known as the trailing P/E.

How is the Schiller P/E ratio different? The earnings per share in the Schiller P/E ratio are the average inflation adjusted earnings for the preceding ten years. The point is that the Schiller P/E ratio gives the investor a better perspective about the earnings of a company over time and not just during the run up of a bull market.

Why Stocks May Fall

Fortune discusses why stocks may tank in the coming year.

One of the best arguments for why 2015 will be bad for the market is that stocks are really expensive. These days, the preferred measure is the Shiller P/E, which is named after the Nobel Prize winning economist Robert Shiller and compares stock prices to the past decade of corporate earnings. By that measure, the market is at 26, well above its 130-year average of 16, and close to where the market has cracked in the past. In mid-2007, the Shiller P/E topped out at 27.5.

This argument makes the point that stocks are overpriced compared to earnings by historic standards. When this happens it typically precedes a large correction or even a market crash. If you believe this line of reasoning it is time to sell overpriced stocks.

Bonds Instead

If you expect the stock market to fall it sometimes makes sense to invest in bonds. Interest rates are not all that high and unless they go up precipitously it is unlikely that you will lose much money compared to what would happen in a market crash with your stock portfolio. It may be a harbinger of things to come that investors are choosing to sell overpriced stocks and buy bonds. CNN Money notes that investors run to bonds in this situation.

The yield on the U.S. 10-year Treasury note has been on a post-holiday weight loss plan. It was around 2.25% the day after Christmas. It touched a low of 1.89% on Tuesday.

Stocks and bonds move around all the time, but the 2% yield is a red-flag threshold. It means that investors are basically willing to accept an interest rate on a bond that will lose them money in the long-term, since U.S. inflation typically hovers around 2%.

If you have been in the stock market during its upward ride for the last few years it may be time to take a little money off the table, sort through your portfolio using the Schiller P/E ratio, and sell overpriced stocks before they become underpriced!

Sell Overpriced Stocks DOC

Sell Overpriced Stocks PDF

Sell Overpriced Stocks PPT

More Resources

Interest Rates and Stock Prices

We recently wrote about possible stock picks for 2014. Because interest rates are likely to rise this year we noted that utility stocks are likely to fall in price. At the same time their dividends will likely remain the same. So we suggested that one might consider buying utilities such as the Southern Company after rates go up. If you believe that the Federal Reserve will continue to pare back its quantitative easing stimulus program, when to sell stocks such as utilities is probably right now. As the economy slowly improves rates will go up and high paying dividend stocks like utilities will go down in value. These are great stocks for the long term but not on the eve of a rate hike. When to sell stocks like these, is when times are good and rates are low. When to buy stocks like these is when rates go up, their prices go down, and the value of their dividends rises significantly.

Overbought Markets and Stocks

There are times, perhaps even now, what an individual stock or the entire market has been going up for months or even years. New investors enter the market with the perception that any stock they buy will go up in price. However, there are sectors such as gold investments that have recently gone bad. It should have been obvious to smart investors that gold would not go up forever. New investors believed the hype that currencies would fail and that gold would be king. The market was overbought and when interest rates started to go up and the economy started to mend and when the US dollar rose, gold took a nose dive and fell more than fifty percent. When to sell stocks is when the entire world is buying them and driving prices up beyond where fundamental dictate. When considering when to buy stocks look at profit to earnings ratios, intrinsic stock value, margin of safety, and technical analysis of market sentiment. When to sell stocks is when these fundamentals are bad and the market is ignoring them.

More Resources

Business risk is the risk of competition. Effectiveness of management, developing and promoting products, penetrating markets, and doing so in the most cost effective and profitable manner all go into a profitable company. Business risk is also economic risk. Macroeconomic circumstances such as recessions and wars can devastate otherwise thriving businesses. New scientific discoveries or new technologies can likewise create new winners and losers. Diversification helps in managing investment risk. Consumer product companies typically do better during a recession than oil companies. Owning different types of stock in several market sectors will protect you from an isolated market downturn in one sector.

Fundamental analysis of stocks includes a careful look at price to earnings ratios and cash flow ratios. These details will tell you if a stock is overpriced or underpriced. They will tell you how effectively the company is using its cash flow. Fundamental analysis of a stock will tell you if it is a good buy or if its success has caused it to become overpriced. Many companies have their day of rapid expansion and eventually grow to a size that inhibits spectacular growth. They are typically priced in anticipation of future earnings. Managing investment risk in buying stocks has to do with not overpaying for popular stocks on the one hand and finding underpriced stocks on the other. It also has to do with being able to define investment risk.

Investment risk management probably best starts with having a clear idea of what your investment goals are and developing an investment plan consistent with your goals. There are many stocks that have appreciated in value over many years. Long term investing is best served by finding underpriced stocks with good prospects, buying and holding. However, almost all stocks suffer when there is a market crash. If your goal is to make a certain amount of money in a few years you may be disappointed when the economy turns sour just when you want to sell and take profits. Managing investment risk for short term goals is easier with trading options where there is profit in both the rise and fall of stock prices. Knowing what penny stocks to watch for short term gains may be a better idea in a volatile market where you want to keep your gains as cash.

Investment risk management works best when you don’t let everyone else’s mood affect yours. Polls tell us that the American public is very pessimistic about the economy despite the fact that the economy is improving, retails sales are coming back, and manufacturing is picking up. Whether you are investing in oil, investing in gold, or investing in beer companies keep your eye on financials and fundamentals as your guide to managing investment risk.

More Resources