In Part I of this article, which I published back on September 28th, I laid out the case for value investing and showed you why it is one of the most popular and widely-followed strategies on Wall Street. In today's lesson I'll bring you a closer look at some of the specific methodologies that I use to uncover quality value candidates.

Before I continue any further though, please keep in mind that individual investors should strive to develop their own unique process for finding undervalued stocks. While my ideas should serve as a good starting point, readers should customize the model to fit their own personal risk tolerance levels, preferred holding periods, and other various financial circumstances.

The process I use to identify winning value stocks can essentially be summed up in three steps:

Step #1:  Screen the entire universe of stocks against predetermined filters. This step is designed to narrow the immense field down to a workable number of potential investment ideas.

Step #2:  Of the stocks that make the final cut, determine the intrinsic and strategic value of those that look most promising.

Step #3:  Build a diversified portfolio of those stocks that are trading at the sharpest discounts to their true value.

While these three steps may sound relatively straightforward in theory, applying them in the real world takes a bit more work. For starters, there is no set blueprint for selecting the parameters used in the initial screening process, and some filters will undoubtedly be more effective than others in pinpointing undervalued stocks. Furthermore, pinning a precise number on a company's intrinsic value is an inexact science. Even complex valuation techniques such as discounted cash flow analysis require a certain amount of guesswork. Finally, while the primary objective of value investing is to find mispriced stocks, I also look for other attributes -- such as turnaround stories, buyout targets, companies with new products, valuable real estate assets, and anything else that could serve as a catalyst to unlock shareholder value.

Step #1 -- Screen the entire universe of stocks against predetermined filters
Starting with a broad universe of more than 10,000 publicly traded stocks, the first step I take is to trim back this field by excluding those that fail to meet my stringent value-oriented criteria. Investors lacking the necessary software can use one of the free stock screeners found online through providers like Yahoo or Morningstar. It should be noted, though, that while screening is an effective tool to help speed up the search process, it will also invariably eliminate a number of attractive companies that may be worth a closer look.

For example, suppose you have been following a growing biotechnology company with a promising new drug in clinical trials. At the current time, this company may not clear one of your investment hurdles -- such as Price/Sales. However, it is quite possible that the new drug could dramatically ramp up sales in the near future. In cases such as this, I wouldn't rule out otherwise solid candidates simply because they come up short based on one arbitrary criterion. Remember -- screens can be tremendously helpful, but be aware that they can also leave some potential gems undiscovered.

One of the first ways I narrow the field is by eliminating very large companies. With much heavier trading volumes and a contingent of equity analysts following their every move, large-cap firms are more efficiently priced -- meaning there are few opportunities to find stocks trading at just pennies on the dollar. For this reason, I find the small- and micro-cap arena to be more fertile ground for uncovering undervalued and overlooked stocks. I suggest beginning with an initial maximum market capitalization of around $100 million. 

Setting this limit will reduce the pool of potential ideas to approximately 3,000 -- a good start, but there is still plenty of room to pare back even further. One possible way to do this would be to exclude companies from certain sectors. For example, you may already own a technology-focused mutual fund and have no need for further exposure to that area. Or, perhaps you think that the outlook is relatively poor for the utilities sector. Whatever the reason, emphasizing or eliminating certain sectors is an easy way to let your personal preferences, background, and interests help frame your investing strategy.

For some investors, sector selection doesn't factor into the decision making process. However, most will find that they are naturally predisposed to having a better understanding of and affinity for certain industry groups. There is much wisdom in the old adage "buy what you know." On the other hand, of course, I would caution against following it to the letter, as having a portfolio that is heavily concentrated in just one or two industries can be highly dangerous. The link below offers a complete list of the entire industry index from Yahoo:
http://biz.yahoo.com/ic/ind_index.html

Step #2:  Of the stocks that make the final cut, determine the intrinsic and strategic value of those that look most promising
Now that the field has been narrowed to include smaller companies that operate in preferred industries, it is time to dig even deeper and begin looking for stocks that are trading significantly below their intrinsic or strategic value.

To begin, I take the first candidate and weigh it against all other companies that operate in the same industry. Because ratios can vary widely from sector to sector, it is important to maintain an apples-to-apples comparison by judging a stock primarily against its peers. For example, a Price/Sales ratio of 1.0 might be considered reasonable for a computer manufacturer, but would be on the expensive side for a grocer.

Income Statement:
One of the best places to begin is at the top of the income statement with revenues. Typically, I will rank from least to most the amount that investors are forced to pay for each dollar of sales. Consider the following example:

In this case, strictly based on Price/Sales alone, Company #3 appears to represent the best value, as investors must only pay $0.50 for each dollar of revenues the firm earned last year. By contrast, shares of Company #1 are trading at four times that level.

I should also point out that while Price/Sales is a commonly-used financial ratio, I prefer to measure sales (among other measures) against Enterprise Value. Enterprise Value is a figure that factors in the value of a firm's equity, cash and debt, making it a truer reflection of a firm's real "price."

Like almost any other metric, valuing a company based on its revenues has its advantages and its drawbacks. Revenues are much more difficult to manipulate or distort than earnings, which makes them a fairly reliable benchmark. In fact, there have been statistical studies that have illustrated the important role that top-line growth plays in growing a business. However, looking at Price/Sales or Price/Enterprise Value in isolation can be very misleading, as companies with very low ratios tend to also have very thin profit margins, meaning only a tiny percentage of those sales trickle to the bottom line.

For this reason, it is also important to analyze the next major line item on the income statement -- gross profits. Gross profit represents the amount of income left over from total revenues after subtracting cost of goods/services sold. Often, I will find companies that generate substantial gross profits and maintain healthy gross margins, but still have trouble showing a net profit. Investors often ignore companies with negative earnings, which allows the value hunter an opportunity to pick up these stocks at bargain prices.

Eventually, some of these companies will identify ways to reduce their overhead costs or trim other fixed expenses, which will in turn let more of those gross profits flow through to the bottom line -- and hopefully lift the share price. Thus, money-losing firms that manage to consistently generate high levels of gross profits will often have a head start on achieving overall profitability.

With so many investors focusing exclusively on net income and overlooking gross profit, I believe the latter can be a powerful measure to help spot hidden value before the rest of the market catches on. In general, I prefer to invest in stocks that are trading at less than three times annual gross profits.

Finally, after ranking each of the firms in the chosen industry according to revenues and gross profits, I then repeat the process with net income. Keep in mind, though, that the impact of non-recurring charges may need to be stripped out. When the earnings picture is clouded by a series of one-time items, adjusted earnings from continuing operations may offer the best insight into where the company is headed.

Also, don't forget to assess the impact of taxes. Some companies may be carrying forward tax losses from prior periods, which reduces current taxes and inflates earnings. In these cases, take a closer look at how much earnings will fall when this temporary tax benefit runs out in future years.

Note: In the coming weeks I'll bring you Part III of this educational series on value investing. In it, I'll take a closer look at how to analyze a firm's cash flow statement and balance sheet. I'll also summarize many of my methodologies and will show you how you can use them to uncover highly undervalued stocks.

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Important Note: The above article was merely a small excerpt from a recent issue we sent to subscribers of our premium value investing service -- Margin-of-Safety Investing. In each issue of that newsletter, editors Nathan Slaughter and Paul Tracy deliver an in-depth look at a variety of other deeply discounted stocks that should provide investors with a solid margin of safety at current prices. To receive your copy of our most recent issue of Margin-of-Safety Investing, as well as other guidance similar to this twice per month, you'll need to subscribe to this publication. To learn more, please visit:
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Thanks for reading!

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