Today's Best Value Picks
Famed hedge-fund manager Leon Cooperman, who describes his investment philosophy as "any stock or bond at the right price," is a dyed-in-the-wool value investor. "I find over the years, if I buy something at the right price, invariably I get lucky," he says in a recent profile on CNBC.com.
From a man with among the best track records in asset management, that may sound like false modesty. But Cooperman's quote highlights a key advantage of value investing: You don't need to know the precise fair value of a company to know its stock is inexpensive, and you don't need to know exactly how value will be realized before you buy.
History suggests all you need to know, at least among viable companies, is that a stock is truly cheap — provided you have the patience to wait until it no longer trades at a discount.
How do you know a company is viable? How do you know a stock is truly cheap? And what if you don't have unlimited patience?
For our money, we want more than viability. By emphasizing companies with strong operating momentum, rising earnings estimates, and good-performing stocks, we can weed out most "value traps" — names that look cheap only because their underlying fundamentals are eroding. We also weed out some true bargains, but we're willing to pay that opportunity cost for the improved visibility and reduced risk that come with a focus on high-quality companies.
Partly because our stock-picking approach was developed with an eye toward selling subscription renewals, we emphasize 12-month returns. We don't want subscribers to buy out-of-favor names that will be even more out-of-favor in a year. So, we look for a catalyst, a reason to think a company could positively surprise in the year ahead. The cheaper a stock, the easier for it to benefit from "good" news.
To improve our odds of uncovering truly cheap stocks, we look for names trading at a discount on several metrics. Our QuadrixÂ® Value score reflects 20 different valuation ratios, including both absolute measures (like P/E ratio) and relative measures (like P/E versus the 36-month average P/E).
Stocks with very high Quadrix Value scores tend to be profitable companies for which expectations on Wall Street are low. Too often, stocks that are very cheap based on only one valuation ratio are special situations that have experienced a one-time surge in earnings or cash flow.
Using several valuation ratios won't reduce the volatility of your portfolio; insisting on across-the-board cheapness will concentrate your holdings in bona fide value stocks, which tend to move together. But using several valuation ratios will reduce the risk of relying on a measure that is inappropriate for a particular company — or a measure that is losing relevance.
To limit volatility, avoid loading up on a single sector or industry group. Also, look for value stocks with appeal beyond their cheapness. That makes particular sense now, as Quadrix Value scores have been less effective than usual when the broad market is expensive. Over the last 20 years, Quadrix Momentum, Earnings Estimates, and Performance scores have been unusually effective when the market is expensive. Also, Quadrix Overall scores have worked well in both cheap and expensive stock markets.
Among valuation ratios, absolute measures tend to be much more effective than relative measures when the market is expensive. Enterprise ratio (enterprise value/EBITDA), price/cash-flow, and price/free-cash-flow — the three valuation measures shown in the table below — tend to work well in expensive markets.
Looking for attractive values always makes sense. But with the average U.S. stock trading at the high end of 20-year norms on most valuation ratios, history suggests this is a particularly good time to look for values among timely stocks with favorable operating, earnings-estimate, and share-price momentum.
Eleven such stocks are listed in the table below. Year-ahead favorites include Focus List picks Alaska Air Group ($49; ALK), Foot Locker ($48; FL), Magna International ($111; MGA), and Whiting Petroleum ($89; WLL).