Three Signals for Value Investors in Today’s Market

In a perfectly efficient market, we could never buy a stock at a discount or sell one at a premium. Every security would be perfectly priced, all the time.

It’s only through irrational, emotion-driven selling that value investors will occasionally get the chance to pick up a $50 stock for $25 a share, or maybe even less.

Value investors are the bargain-hunters of the investment world. Our job can be tough when the market is booming and nobody wants to part with their stocks. But when the cries of “sell” reach a crescendo and investors can’t exit their positions fast enough, shopping is good. Yet these opportunities come around once or twice a decade.

The last time the market traded at such marked-down prices was in 2002. Stocks went into recovery mode shortly thereafter and rebounded almost +30% during the next 12 months. Few investors would turn their nose up at such a gain today. But that increase in valuation was in the overall market. Plenty of individual stocks netted investors ten times that.

As fear flooded the market and corrupted rational decision making, downtrodden investors were willing to sell outstanding companies for a fraction of their value. Research In Motion (Nasdaq: RIMM) went for a split-adjusted $5 a share. Apple (Nasdaq: AAPL) sold for just $12.

Forward-looking investors who took advantage of the rampant pessimism have since been rewarded with massive gains of more than +1,370% for RIMM and more than +1210% for AAPL. And those are hardly isolated examples.

That’s why long-term investors should cheer the irrational dumping of high-quality securities. If you walked into Best Buy or Target and found row after row of brand-name merchandise marked down -40% or more, you would probably load up the shopping cart. Investors don’t shop that way. They tend to fear massive stock declines rather than embrace them as windows of opportunity.

The investors who throw in the towel miss the chance for big gains. Now is the time to buy, not sell.

The First Signal: Low P/E Ratios

Price/earnings ratios can offer clues as to whether a stock is undervalued. Comparisons are best made within industries, evaluating companies against their peers or with their own historical valuation. If a company with an undamaged outlook typically commands 20 times earnings but is suddenly selling at 10, its stock might be a strong value play.

During the past 20 years, the S&P 500 has traded at an average P/E of 20.5. It now trades at 15.5 times earnings. Ninety-nine of the index‘s 500 holdings have earnings multiples below 10. The last time P/E multiples fell this low was in 1997. Stocks then rocketed to new highs, enjoying a multi-year rally.

The Second Signal: Price-to-Earnings Growth Ratios

PEs aren’t perfect: They show the past. What about a company’s growth potential? Two stocks trading at identical P/E ratios might seem equally valued. But what if the first company were expected to deliver earnings growth of +10% and the second was projected to grow +20%?

All things being equal, you’d clearly prefer the second company.

Companies that may seem expensive on the surface can turn out to be undervalued once their future growth potential is factored in. Investors who automatically dismiss stocks with seemingly high P/Es could be missing out on some of the market’s most extraordinary opportunities.

To determine this, use the price-to-earnings growth or “PEG” ratio. It’s calculated by dividing the P/E ratio by a company’s annual earnings-per-share growth. Slow-growth companies have a higher PEG ratio than faster-growing companies. A company with a PEG ratio of one or less is considered to be a good investment.

Legendary money manager Peter Lynch said that when you find a stock with 25% growth trading at just 20 times earnings, it’s time to “back up the truck.” A modest earnings multiple with a low PEG ratio is a recipe for profits — one that gets richer as the P/E ratio falls.

The Third Signal: Dividend Payouts

The S&P’s current dividend yield of 2.8% is 100 basis points higher than two years ago. There are scads of double-digit yielders out there whose rich yields will evaporate as the market’s valuation returns to historical norm. Investors who buy while yields are high capture these outsize payout rates. They not only collect a rich income stream, they also are in line for robust capital gains when the overall market picks up.

Aberdeen Australia Equity Fund (AMEX: IAF) saw its yield spike up in August 2007. Investors who bought to capture the yield of 11% saw their shares jump from $12.50 to $17.50 in less than two months.

This just goes to show how quickly these high yields can disappear if you don’t lock them in.

Now Is the Time to Get In

There are two ways to look at this year long sell-off. It’s either a nightmare or a dream come true.

Yes, most of the companies you follow (or own) are down alarmingly from their peaks. But as Warren Buffett astutely reminds us, successful investors don’t rent stocks, they own businesses. And right now, many of the world’s most powerful companies can be purchased at low prices and with yields that haven’t been seen in decades.

Thanks to the market’s manic-depressive mood swings, you can take advantage of this clearance sale and make your investment dollars work harder. But as investors come to their senses, these deals will disappear.