11 ways to find the perfect value stock

Buying stocks for less than they are worth will never go out of style. Recently however, there have been increasing interest in ‘value’ as prices have appreciated significantly since the last major sell-off.

Value investing is not simply a case of buying on a low multiple, and there are differing views on what to look for. So, Livewire has reached out to four successful Australian value investors; John Abernethy, Roger Montgomery, Wayne Peters and Ben Rundle, asking them “what are the characteristics and key metrics that define a value stock?” Learn their views on the most important metrics to assess, as well as what to look for to ensure the sustainability of a company’s proposition over the long-term, by accessing the wire below.

Return on equity versus cost of equity

John Abernethy, Chief Investment Officer, Clime Asset Management

We see value as intrinsic in nature, determined by our assessment of a business’ sustainable return on equity (ROE) relative to its cost of equity (COE). We believe companies with a higher ROE and lower COE are better placed to sustainably grow shareholder value. Under this framework, a low P/E or P/B ratio doesn’t necessarily equate to a “value stock”.

A low P/E or P/B ratio doesn’t necessarily equate to a “value stock”

Other considerations that need to be considered are the extent to which retained earnings can be reinvested back into the business without diluting its overall ROE, and the degree to which the balance sheet is attributed to tangible versus intangible assets, where our clear preference is the former.

Acquire more than what you paid for

Ben Rundle , Portfolio Manager, NAOS Asset Management 

The definition of value investing that we subscribe to is “acquiring more than what you are paying for.” Often investors will associate ‘value’ with only those companies trading on a low price to earnings ratio or a low price to book value. That is often the case but certainly not always. For example, if Company A consistently has a higher return on invested capital than its competitor Company B, then we may be happy to pay a higher price for Company A and still consider that as the ‘value’ play of the two.  It won’t simply be a case of a lower multiple, but rather what we pay versus what we are getting in return. That relationship is the key to value investing in our view.

The most common form of value investing at NAOS is in companies that are trading on a low earnings multiple or low price to book, have a very strong balance sheet, strong management and we can see a path to increased earnings growth, where it may have been depressed temporarily.

Numbers are only part of the story

Wayne Peters, Chief Investment Officer, Peters MacGregor

Buying a value stock simply means paying less for a stream of cashflows than they’re worth. Regardless of whether a company’s earnings are growing quickly or slowly, the key is getting more than you’re paying for. While creating a discounted cashflow model can be as simple or as complicated as you like, the numbers are only part of the story. What matters is how accurately you can forecast them, and how prone to error your assumptions are, either through incorrect analysis or bad luck.

It should never be forgotten how ruthless business competition is. Like the multitude of financial metrics that exist, historical earnings growth, return on equity and incremental return on investment tell you a lot about the past. But they don’t necessarily tell you much about the future. A company’s ability to grow and defend its market position without losing its pricing power is the key to owning businesses that can multiply their earnings over time.

A company’s ability to grow and defend its market position without losing its pricing power is the key to owning businesses that can multiply their earnings over time.

Value is what you get

Roger Montgomery, Chief Investment Officer, The Montgomery Fund

We aren’t buying stocks to bet on ‘up’ and ‘down’, which is akin to betting on black or red at the casino. What we are doing is buying a share of a business.  There is the price of the share, and there is value of the business.  The business increases in value by retaining profits and generating attractive returns on that incremental equity.  As the equity increases and the returns are maintained, the business is more valuable, and a future buyer is willing to pay more.  So, price is what you pay and value is what you receive.  Your job is simply to pay a lower price than the value you receive. 

The challenge is estimating the value, which is essentially an estimation of the future cash flows that will flow out of the business.  Because these estimations are likely to be very wrong, it is important that we pay a price that offers a margin of safety between it and the estimated value.  After three decades of declining interest rates, investors have been lulled into believing they will always remain low.  We don’t believe low rates are sustainable, so we have not adopted lower discount rates when valuing companies.  The result is we haven’t chased higher prices and we have missed out on some of the gains.  Our clients however don’t care whether we participate in the last 1 or 2% of the gains. They just don’t want us to lose 50%.

It is important that we pay a price that offers a margin of safety between it and the estimated value.