Three Value Strategies You Can Use to Beat the Market Today

Nathan Slaughter's picture

Tuesday, February 10, 2009 - 2:31pm

by Nathan Slaughter

Nobody likes to see daily bloodletting in the market. But look on the bright side. While these downturns can be frightening, think how different investing would be without them. 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 occasionally get the chance to pick up a $50 stock for just $25 per share, or possibly even less.

Value investors like myself are the bargain hunters of the investment world. And when the market is booming and nobody wants to part with their stocks, our job can be tough. But when bearish sentiment reaches a crescendo and investors can't exit their positions fast enough, shopping is good.

Unfortunately, these rare buying opportunities only come around once or twice a decade.

The last time the entire market traded at such drastically marked-down prices was back in 2002. As you may recall, stocks went into recovery mode shortly thereafter and rebounded almost +30% over the next 12 months. Few would turn their nose up at that type of gain today. But that was just the broader market -- a number of sharply underpriced stocks could have netted you gains ten times that size.

As fear flooded the market and corrupted rational decision making, downtrodden investors were willing to sell you quality companies like Research In Motion (Nasdaq: RIMM) for a split-adjusted $5 per share or Apple (Nasdaq: AAPL) for just $12 per share.

Forward-looking investors who took advantage of the rampant pessimism have since been rewarded with massive gains of more than +1,200% for RIMM and more than +750% for AAPL. And those are hardly isolated examples.

Don't Let Fear Make You Miss the Rebound
That's why long-term investors should be cheering this irrational dumping of quality stocks. If you walked into a retail outlet like 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. However, though it may seem counterintuitive, investors aren't wired quite the same way and tend to fear massive stock declines rather than embrace them for what they really are -- golden windows of opportunity.

During turbulent times when the market is in freefall and the economy is floundering, it's all too easy to fall prey to doomsday thinking and throw in the towel. However, this is the time to remain cool and calm -- and pounce on those unloved stocks at wholesale prices.

At this point, the whole market is undervalued and poised for a rebound once confidence returns. But just as we saw in 2002, you can bet that some stocks will undoubtedly emerge as market leaders and sprint far ahead of the pack. To pinpoint these future winners, there are three time-tested strategies that value investors can use.

Strategy #1 -- Astonishing Value Plays
Price/earnings ratios can be fairly blunt instruments. However, they do give us a pretty good idea of what investors are typically willing to pay for a company relative to every dollar of earnings it generates. And they can also serve as a broad indicator of whether a stock, a specific sector, or even an entire country is undervalued or overvalued.

Of course, some industries traditionally trade at relatively low earnings multiples even in good times, so they might not be as cheap as they seem at first glance. Therefore, it's usually a good idea to compare a stock's P/E to that of its peer group and its own historical average. If a quality company with an undamaged outlook typically commands 20 times earnings but is suddenly getting only 10, then you may have a viable prospect.

The last time the S&P 500 P/E ratio was this low, stocks promptly took off on a multi-year tear.

Over the last 20 years, the S&P 500 has traded at an average P/E of 23.3. Now it trades at 14 times earnings. 222 of the 500 holdings have P/Es below 10. And 478 of the 500 are trading below their 20-year average multiple. The last time P/E multiples fell this low was in 1997. You can see what happened next -- stocks enjoyed a multi-year rally and rocketed to new highs.

Strategy #2 -- Cheap Growth Plays
As you can see, P/E ratios are useful in identifying severely underpriced stocks that may be poised for a dramatic recovery. However, like any metric, they don't tell the whole story. After all, they say nothing about a company's future growth potential. Two stocks trading at identical P/E ratios might seem to be equally valued. But what if the first company was expected to deliver earnings growth of +10% annually and the second was projected to boost its bottom line by +20% per year?

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

Companies that may seem expensive on the surface are actually undervalued once their future growth potential is factored in. So investors that automatically dismiss stocks with seemingly high P/Es could be missing out on some of the market's most extraordinary opportunities.

I've found 146 stocks selling for earnings multiples below 10 that are projected to grow more than +25% next year. Legendary money manager Peter Lynch once said that when you find a 25% grower trading at just 20 times earnings, it's time to "back up the truck." So can you imagine the potential gains waiting for investors that can find the same promising company trading at a rock-bottom P/E of 4?

I've found a liquor distributor in exactly this situation right now. Once this stock regains its normal P/E of 22.6 that it averaged for the past 10 years, you could be sitting on $5.70 for every $1 you invest now -- and that's assuming the company doesn't increase its profits by a single penny.

Strategy #3 -- Fat Dividend Plays
There is another silver lining to the market's precipitous plunge: dividend yields are at historic highs. You don't always get this gift when stocks drop. When the tech bubble popped yields rose a bit, but that was nothing compared to what we are seeing today.

There are scads of double-digit yielders out there. For example, dull oil pipeline operators that typically yield 5% to 7% in normal times now sport enticing yields of 12%.

These rich yields don't last for long. When the market returns to normal, payouts could well slide back to 6% -- but for investors who act today, you will have doubled your money by that point. Better still, if that same pipeline operator increases its dividends over the next few years (as most do), you could soon be earning 15%, 18%... even 20% or more on your initial investment. 

Aberdeen Australia Equity Fund (ADRs95: 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 act to lock them in.

Now Is the Time to Get In
There are two ways to look at this tumultuous year-long sell-off in the market: It's either a frightening nightmare or a golden window of opportunity.

Yes, most of the ticker symbols 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 levels and with yields that haven't been seen in decades.

We even found one shipping company that enjoyed a stable 8% yield for years -- until this market discounted its price tag. Now you can get the same stock with a yield closer to 20% -- thanks to its lowered price and the fact that it raised its dividend distributions every quarter in 2008.

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. To discover what we're doing and learn more about some of our favorite new ideas, just follow this link.

Nathan Slaughter does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.