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2 ways I find value stocks

There are many different ways to invest. You could invest for growth, or for income. You could invest in real estate, or you could get involved in index investing. You might also choose to invest in value stocks. If you do choose to follow in the footsteps of giants like Warren Buffett and Peter Lynch, here are two principles you should consider when assessing your investment landscape.

1) Skew small and obscure

What makes a stock cheap? Price is simply a reflection of the demand for that stock at any given moment in time. Whether that price accurately represents the stock’s intrinsic value is another question. As the great value investor Benjamin Graham once said, “In the short run, the market is a voting machine, but in the long run it is a weighing machine”. In other words, prices can be be out of line with intrinsic value for a while, but over time they will re-adjust.

As value investors, we are looking for opportunities to buy these undervalued securities. Therefore, we are looking for stocks that have relatively low demand. The fewer buyers there are, the less the price will be bid up. This will typically mean that we are looking at companies with smaller market capitalisations than those that you may see on the front pages of the business newspapers.

Smaller companies are also relatively underfollowed by analysts. Large companies, on the other hand, are usually followed by at least two or three analysts from each of the major investment banks. As huge institutions, they are privy to much more accurate information than the average retail investor, meaning that the cards will be stacked against you from the outset. You are far more likely to find an edge in an underfollowed stock than in the large caps.

2) Boring is good

In a similar vein, value is often found in industries that many lay people would consider bland or boring: telecommunications, logistics, industrials, and so on. The dullness of these sectors acts as a filter against the wave of casual buyers who will get easily excited about the next big tech stock. Going back to our discussion of price dynamics, what do you think happens to a hot new technology stock when a large number of casual investors jump on it? The price shoots up. This is unlikely to happen for a ‘boring’ oil company.

Now, it may be possible to make money by timing your entry into these stocks by employing swing or momentum strategies. But this is difficult, and there is much research to suggest that success in this endeavor is largely a product of one’s luck. It is far easier to study the cyclical patterns in sectors like energy, telecommunications and transportation, and to look for value plays in these more predictable markets. It won’t make you a millionaire overnight, but are you really in that much of a hurry?

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Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.