Deep Value Investments: How to Find Your Portfolio’s Next Superstar
by Floyd G. Brown, Advisory Panelist, Investment U
Wednesday, August 20, 2008: Issue #842
Protecting investment principal and your profits should be a concern in any market, much less a bear market. Contrarian investors looking for deep value investments can find themselves walking a tightrope between “buying on the cheap,” and “buying garbage.”
And in the down markets like we’ve been in, it can be hard to distinguish between the two.
Nevertheless, keeping a portion of your portfolio in contrarian and deep value plays can be hugely profitable. The possible rewards of double-digit plus returns from these “portfolio superstars” are the stuff cocktail-party stories are made of.
The last year has been painful for the market. Record numbers of stocks are in the gutter, and cheap stocks seem to be everywhere. Many of these shares are selling at a discount not because of poor performance, but simply because of negative investor psychology. Here’s a strategy for finding these bargains, and separating them from the companies on their deathbed.
Deep Value Investments - Screen Stocks Like a Professional
I like to use an ordinary stock screener when I’m screening for deep value investments, but if you have one you like, use whatever you’re comfortable with. If you don’t use one on a regular basis, try Yahoo’s stock screener. These are great tools to start off a potential investment search that many professionals wouldn’t be caught without.
Open up your screener, and let’s find some deep value investments…
We want stocks on the major indexes that are trading like penny stocks (stocks trading below $5 a share). At Investment U we generally don’t advise investors to purchase penny stocks, because there are a lot of good reasons these companies are priced so low. However, the market is not a rational system. It behaves irrationally and over-reacts. This has created some exceptions for the contrarian investor…
Set your first criteria on the screener under “Share Performance” for “Current Price” with a condition of “<=” and a value of “$5.” (Companies trading less than or equal to $5.00 a share.)
Next, we will look at valuation. There are a number of metrics we could use like price-to-earnings (PE), price-to-cash flow or price-to-book value. However, today I want to look at price to sales (P/S) ratio. By screening for these super cheap firms trading at less than one times sales you are paying less than $1.00 for a $1.00 in sales.
Set your second Criteria under “Valuation” to “P/S” with a condition of “<=” and a value of “1.” (Companies with a P/S ratio of less than 1.)
Hmm, what do we find? We find a mix of beaten-down companies including financials, media firms, tech firms, auto related firms, a couple of airlines and even some consumer names. The screener returned over 200 stocks from this simple two-factor screening. I find that by looking at the largest companies you can find the ones best suited to weather economic downturns.
In reviewing the list, I am looking to identify companies with profits, cash flow and the ability to continue to make debt payments.
3 Possible Deep Value Investments
Here are three of the firms that caught my attention as possible deep value investments:
- Qwest Communications (NYSE: Q) is trading at $3.85. This telecom firm gets no respect. It is the product of the ill-fated merger of long distance provider Qwest and the old regional Bell firm US West. As the firm loaded up on debt for the merger, the business swiftly changed. It has been plagued by the cancellation of landlines. In addition, its core business is shrinking. If its customer base stabilizes, and if it’s able to leverage its network, its debt will go down. Without a mountain of debt to dig out from, shareholders should see profits hitting the bottom line, and their wallets.
- 3COM Corp (Nasdaq: COMS) is trading at $2.20. Last year, the Chinese and Bain Capital tried to take this computer-networking firm private. The Pentagon blocked the sale because of national security concerns. Why? The technology this firm controls is vital to national security in everything from handheld devices to networking applications. Security personnel are currently watching over the Olympic Games via IP-based surveillance cameras, thanks to networking provided by 3Com. Quarterly earnings at 3Com are improving, and the share price action is more the result of the broken leveraged buyout than the state of the company.
- American Shared Hospital Services (AMEX: AMS) is trading at $2.17. This firm helps hospitals acquire the Gamma Knife equipment used in advanced radio surgical and radiation therapy services. This company was known for paying a healthy dividend. But late last year management decided to cut the dividend to reinvest the cash in growing the company. Shares were punished as income investors fled. The AMS Chairman, Ernest Bates MD, is bullish on the future saying in the last company conference call that earnings results “show how our strategy to use AMS’ creative financing solutions to make proton beam radiation therapy (PBRT) systems, Leksell Gamma Knife PerfexionTM systems, IGRT systems and other next-generation devices for radiation oncology delivery available and affordable to our clinical partners and their patients has put us on the path for long-term growth.”
With a little research you can find that this current market correction is just the opportunity that deep value and contrarian investors like myself love to see. So fire up the stock screener and find your portfolio’s next “superstar.”
Good investing,
Floyd
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Today’s Investment U Crib Sheet - The 3 Major Stock Exchanges
Stocks trading below $5.00 are considered “penny stocks” and carry much more risk than ordinary stocks.
Traditionally, the definition of a penny stock is a stock with a price under $5.00 that is trading on the over-the-counter-bulletin-board (OTCBB) - also known as the “pink sheets.”
The reality is that many of these companies are “cheap” for a good reason, and should be avoided for anything other than pure speculation.
But there is a way to see if a company has suddenly fallen on hard times, or if it’s been in the “loser” pile for while. And understanding the exchange a company is on - and their listing requirements - can give us an insight into a company’s financial situation.
Each exchange has certain requirements that each company must meet in order to be listed with them. Those failing to meet requirements may be delisted. There are three major exchanges that provide a market for stocks…
- New York Stock Exchange (NYSE)
Companies must have a market capitalization greater than $100 million, and aggregate three-year pretax earnings of more than $10 million. - National Association of Securities Dealers Automated Exchange (NASDAQ)
Minimum share price of $5.00, and a prior 12-month average of $550 million market capitalization. - American Exchange (AMEX)
Companies must have a market capitalization of at least $4 million, and pre-tax income of at least $750k. - Over the Counter Bulletin Board (OTCBB)
No eligibility requirements. This is where stocks are traded that cannot meet listing requirements for a major exchange. Stocks listed here should be handled with caution, and the understanding that there is a greater degree of risk associated with them.
Just because a company is listed on one exchange, doesn’t mean it doesn’t qualify or can’t move to another. Microsoft (Nasdaq: MSFT) for example, trades on the Nasdaq, but that doesn’t mean it doesn’t have the financial strength to qualify for listing within the NYSE. It chooses to remain on the Nasdaq.
The exchange a company is listed on is up to them as long as they can meet the requirements, and shouldn’t be a sole indicator of financial health. But it can be important to know that a company listed with the NYSE has higher financial hurdles than one listed on the OTCBB.
Having a basic understanding of exchanges and their listing requirements can give you a leg up on the average investor. It can also help you separate penny stock losers from good companies in the penny stock bargain bin.
Alex Green recently showed us how to size up a penny stock… And three good reasons why we should avoid them in Investment U Issue #646, Penny Stocks: Can You Really Make a Fortune in Penny Stocks… or Do You Simply Get What You Pay For?
Related Articles:
- The Energy Sector: Another Solid Industry Goes “On Sale”
- Position Sizing: Why Not Using This Strategy Is The Best Way to Lose Everything
- Buying Bank Stocks: Good Bet or Big Gamble?
