With the S&P 500 trading at nearly 20 times earnings, it’s a challenging time for investors to find value in the market. That makes it more important for investors to stick to a disciplined approach. You can still find value even in a pricey market.
1. Look for Bargains – Don’t Overpay
This is one of the main principles of value investing, from Benjamin Graham to Warren Buffett. But just what does it mean? There are many measures of value, but basically it means don’t pay more than what you think a stock is worth. The goal is to buy a good stock cheap. Cheapness isn’t necessarily indicated by stock price alone.
A stock’s valuation or its price-to-earnings ratio (PE) can be a quick indicator of value. If you have a stock that historically sells at a PE of around 10, which means you’re paying $10 for each $1 of earnings, yet it’s selling at a PE of 7, you might have a bargain. Conversely, if it’s selling at 15 times earnings when it usually sells for 10, that’s likely not a bargain. You should always compare a stock’s PE to its historical PE, or to others in the same industry, as different industries vary in their average PEs.
Let’s look at two well-known stocks. Automaker Ford (NYSE: F), for example, is selling at about 9.5 times earnings, while General Motors (NYSE:GM) has a PE of 22. Right away, you’d say that Ford is the better value.
2. Look for Quality – Good Fundamentals
Value investing and fundamental investing involve looking at the underlying business of the stock. Look at the financial statements to check out the company’s cash and debt, its revenue and income. Warren Buffett always spoke of buying a stock as if you’re buying a piece of the business.
You can look at specific business or industry indicators, too. For example, with Ford and GM, you should not only look at their financials, where you’ll notice that each company’s revenue has fluctuated, but also gauge the trend in the auto business. Are sales rising? Peaking? How is the economic outlook for auto sales? You’ll find that the auto industry overall is still in a long-term recovery since the Great Recession.
Sometimes companies that have had strong sales and earnings hit a temporary snag in a quarter or a year. Their stock prices often fall as many investors sell, leading these stocks to become bargains, as other investors judge that the businesses will rebound.
J.M. Smucker (NYSE: SJM) comes to mind as its business has been temporarily hurt by rising commodity prices for its coffee. A stock like Radio Shack (NYSE: RSH), on the other hand, is an extreme example of a company whose business has been permanently damaged and may be headed for oblivion.
3. Dividends – A Value Factor
Some investors ignore dividends. Others buy dividend stocks simply for income. But the power of dividends goes beyond even their considerable strength to compound from small amounts of money into large.
Dividends are often an indicator of value. When companies consistently pay dividends over long periods of time and, more importantly, increase those dividends, it helps encourage share price appreciation as well.
Strong dividend-paying and dividend-raising companies usually have strong businesses at their core. Often large companies with sustainable moderate yields are good stocks for value investors to focus their search on. Many Dow Jones Industrial stocks fit that bill.
A variation on the strict bargain hunting method is to look for stocks with businesses that are doing well but with average share prices – what is termed “fair value.” Investors might wait for a slight pullback or price correction on the stocks, then buy.
It’s maybe not pure bargain hunting as much as it is a combination of buying for value and growth. Investors buy these stocks for “growth at a reasonable price.” You still don’t want to overpay. For example, biotech and railroad stocks recently fell temporarily out of favor and became attractive.
If you keep these four simple tips in mind in their search for value even in this high-priced market, you can still reward yourself with big returns. It may not exactly be a stock-picker’s market. But if look hard enough, there’s value still out there.
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