As investors, those who have adopted a value philosophy must feel comfortable going against the grain. While it sounds relatively simple in theory, it can actually be quite difficult in practice to buy when it seems that everyone else is selling -- and vice-versa. However, it is precisely this contrarian approach that allows us to identify unloved (and undervalued) stocks that Mr. Market has unfairly beaten up or overlooked.

Unwittingly, the Roman poet Horace provided an inspirational quote for value investors, saying: 

"Many have been restored that were fallen. And many shall fall that are now in honor."

It is doubtful that Horace was referring to the stock market, but the comment is applicable to investing nonetheless. History has taught us that trends don't last forever -- falling stocks will inevitably rebound, and rising stocks will eventually falter.

However, most investors seem to disregard this important truism and act as if the current trend will continue indefinitely. How many times have we seen novice investors panic and sell after a sharp market correction, or wait to buy until after a rally has carried stocks to new highs? Considering that a sell-off often leaves the market underpriced and a bull market overpriced, the exact opposite strategy would usually be far more profitable.

The illogical, emotion-based trading of many unsophisticated investors is exactly why it is important not to follow the crowd -- and why contrarians often have an edge.

Over the long haul, those who have the faith to buy when the market has been dropping will ultimately be rewarded. Why? Because equity prices have a tendency to revert to the mean. Studies have conclusively shown that when stock prices get overextended to the upside, they eventually fall back in line. And when they have been pushed sharply below their long-term averages, they will soon begin to recover.

The research conducted by MIT finance professor Jonathan Lewellen has given much credibility to the theory of mean reversion. According to Lewellen's findings, up to 40% of the market's annual returns are temporary, and will usually reverse within the next 18 months. Curiously, he also found that a stock's 3 and 5-year trailing returns are negatively correlated to the subsequent 12 to 18 month period. In other words, tomorrow's stock prices will often move in the opposite direction of yesterday's.

This pattern is not a new development. In fact, according to finance professor and noted author Jeremy Siegel, stocks have consistently gravitated towards their long-term moving average since 1802. One of the furthest deviations from the norm occurred during the tech bubble of the late 1990s, and we all know how powerful that reversion to the mean proved to be.

However, stock prices do not exactly snap back into place overnight. They can remain overvalued or undervalued for extended periods of time. This is fortunate for value investors, as inefficient markets allow us time to spot opportunities and take action.

How to Identify Beaten-Up Stocks

So what methodology do I use to find undervalued companies trading well below their intrinsic values? Well, value is not always easy to identify. If it were, then investors would quickly pile into undervalued stocks and would drive the shares immediately higher. Therefore, it is often necessary to look past the headline numbers -- like revenues and earnings -- and dig deeper into each company's fundamentals.

Regular readers are probably aware that I am often drawn to firms with strong underlying business models that are suffering from temporary problems. Such companies often have solid balance sheets, understated tangible and intangible assets, and a healthy level of gross profits relative to enterprise value. Often, these companies are engaged in turnaround efforts or can find ways to cut costs and improve profitability.

Generally speaking, I take a bottoms-up approach to finding new investment ideas. That is to say, I am primarily interested in evaluating stocks on a company-by-company basis and am less concerned with the direction of the overall economy, interest rates, labor markets, energy prices, and other macroeconomic variables. Over the long haul, a company's true value will shine through regardless of these factors.

It stands to reason that most beaten-up value plays will have a few flaws, such as legal problems, falling revenues, deteriorating margins, or customer retention issues -- just to name a few. However, in most cases, this type of bad news is already priced into the shares. To a certain extent, investors have low expectations for these companies and tend to shrug off mediocre results -- and reward any upside surprises.

Usually, I target companies that are trading at a sharp discount to their industry peers and have a measurable margin of safety. However, as noted earlier, undervalued companies can remain that way for months, or even years. Eventually, the market will recognize a company's true value and assign it a more accurate price tag, but that can take time. Therefore, it's always nice to find troubled companies that have a catalyst to improved performance.

It should be pointed out, though, that mean reversion should not be used as a substitute for due diligence. Yes, many quality companies that have been oversold will bounce back in time. However, others have serious issues that warrant the lower price. Here is a checklist of some common traits I examine to distinguish between the two...

• Make sure that cash flow from operations is at least keeping pace with net income. This will ensure that a company is generating quality earnings.

• While there are valid reasons why a company might need to tap its cash supply occasionally, be cautious of those that are quickly burning through their cash and reporting consistently weaker cash flows.

• Focus on companies that have healthy balance sheets and are not saddled with hefty debt loads. Some leverage is fine, but I prefer companies that pay down their debt and maintain reasonable debt/asset and liquidity ratios. This lends more flexibility to the business.

• Net tangible assets should at least keep pace with (if not grow faster than) reported earnings.

• Look for companies that efficiently deploy their assets, as measured by return on assets (ROA) and other related metrics. An improving revenue/asset figure is also a good sign that shows an ability to squeeze more sales from existing assets.

• Watch out for dilution, which can gradually water down the value of your shares. A steady increase in the outstanding share count -- whether by a series of dilutive acquisitions, excessive options, or some other cause -- should serve as a red flag to investors.

• If possible, focus on companies that have a sustainable competitive advantage. This will ultimately manifest itself in greater market share and rising profit margins.

• Invest in firms that have seasoned, trustworthy management teams. Those with serious corporate governance issues are not worth your time or money. Also look for executives that are fairly (but not excessively) compensated and have a history of recent insider purchases.

• Don't ignore attractive gross profits. If a company can trim expenses, then more of this money will eventually flow to the bottom line and strengthen its earnings picture.

Obviously, there are many other quantitative and qualitative criteria that must be evaluated. However, if a company that has recently been placed in Wall Street's garbage bin by shortsighted traders still manages to score well on this checklist, then odds are excellent that the shares will reverse course sooner or later. If nothing else, it should at least be considered a promising candidate that deserves a spot on your radar screen.

I sincerely hope you've enjoyed today's report on the importance of mean reversion.

---------------------

Important Note: The above article was merely a small excerpt from a recent issue we sent to subscribers of our premium value investing service -- Half-Priced Stocks. The mission of Half-Priced Stocks is to help our readers identify securities that are trading at the steepest discount to their intrinsic net worth. In some cases this discount can reach up to 50% or more, giving savvy value investors the chance to purchase quality stocks for just pennies on the dollar. To receive your copy of our most recent issue of Half-Priced Stocks, as well as other guidance similar to this twice per month, you'll need to subscribe to this publication. To learn more, please visit:
https://www.streetauthority.com/subscribe-hps.asp

Thanks for reading!

Income Security of the Month Our "Income Security of the Month" for July 2008 invests in a fast-growing overseas market that doesn't get much exposure in the mainstream financial press. And although it typically makes enormous annual dividend payments -- it has paid an average dividend of 24.9% per year over the past five years -- this fund is perhaps most appealing for its total return potential. Specifically, the fund has delivered total returns of +263.9% since 2003, and it ranks in the top 10% of its category over the past decade.

Top 10 Stocks for 2008! Since we began publishing this report back in 2003, the picks we've featured have consistently beaten the broader market -- delivering average gains of +21.3% per year and outperforming the S&P by a nearly 2-to-1 margin. Act now to reserve your copy of our newest report -- Top Ten Stocks for 2008.

 

Success Trading -- 365 Days Without a Loss Success Trading Group scored 52 wins in 52 weeks! Get their weekend newsletters free.  High-Yield Investing If you're looking for both high yields and enormous capital gains, then you need to learn more about our "Income Stock of the Month."	Stephen Leeb's Market Forecast Receive a free ongoing, PhD level Wall Street education in how the markets work so that you can see into the future and position yourself accordingly. Investor's Business Daily (IBD) Get 10 Free Issues of Investor's Business Daily (IBD) – Plus 2 Free Weeks of Investors.com