Alright, so you’ve decided to become a value investor. How do you go about finding stocks with an intrinsic value much higher than their prices? One place many investors start is with a screen. There are a number of tools available online. I like Zack’s stock screener. The question then is what do you screen for?
Price to book less than 0.67
The book value of a company is the accounting value of all of its assets minus the accounting value of all of the liabilities. The theory here is that if the company in questioned is worth its accounting value, then you would make 50% on your investment. As of October 25th there are 703 companies on the screen that satisfy this criteria. At this point the question becomes, are the assets that the company owns really worth their accounting value. This can be very difficult. Studies have shown that the stock price of companies with low price to book ratios outperform companies with high price to book ratios. If you think that 703 companies are too many to go through you can go ahead and add more filters. I’d be inclined to demand that the company be profitable over the last 12 months. You can do this by going to “Income Statement and Growth” and demanding that “net income is >= 0”. This reduces the number of companies from 703 to 375 companies. One thing that I generally demand is that the company is very small. I assume, perhaps incorrectly, that smaller companies are less covered by analysts and therefore I assume that it is more likely that stock prices could diverge from the true value of the company. I therefore also limit the market cap to be below $100 million. This reduces the number of the companies in the screen to a much more manageable 101.
Price to earnings of less than 10
Ultimately a share in a company is a claim on the earnings of that company. The point of owning a company is ultimately to share in the profits of that company. The lower the price to earnings ratio the less a dollar of profits costs you to buy. This seems straightforward, if you could buy one business generating $100 per year for $1000, or you could buy another business generating $100 per year for $1500. All things equal you should prefer the cheaper company. If you use the screener (under “valuations”) to screen for stocks with a trailing 12 months P/E of less than 10. The number of companies matching this screen is 599. We also don’t want negative P/E ratios as that indicates that the company is losing money, so we need to add net income > 0 as well. This drops the number of companies matching the screen to 526. If you further demand that the market cap of the companies is less than $100 million you get a list of only 137 companies.
The goal here isn’t to then put money into each of these companies, but instead to provide ourselves a starting point. My plan is to use this list to look more closely at Sorl auto parts (SORL), Skypeople fruit (SPU), and Orange City Bus (OCBB). If none of these companies prove to be interesting we come back to the list. Now, you’ll want to find more ways to screen for companies as you may miss some good bargains; companies might have highly valuable real-estate with appreciation that hasn’t been reflected in the book value. Another option is to simply run a screen for companies trading at a low P/E (price to earnings) and low P/B (price to book) and buy them all as a basket. Studies show that this approach has historically outperformed the market. I think that we can do better by studying the individual companies more carefully and using this as a starting point.