How to beat the market: five value stocks that make the grade

We all love a bargain, and when it comes to investing, bargain hunting can be very profitable.

So-called value investing is one of the oldest documented strategies that beats the market.

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However, attempting to buy shares on the cheap is a risky game.  It also requires investors to go against some basic human instincts. And dated accounting standards cause problems when it comes to valuing shares.

But done right, value investing can highlight great opportunities.

By way of example, a by-the-numbers approach I tracked for Investors Chronicle magazine for a decade while working there until late 2021, managed to outperform the UK market by 242%. It is one of four strategies covered in my book Four Ways to Beat the Market.

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Before delving into the detail of the strategy and looking at the stocks it is currently highlighting, it’ll help to understand what value investing really is, why it works, and the traps value investors can fall into.

What is value?

Some argue all investing is value investing. After all, no one wants to overpay for a share.

The value investing we’re going to explore, though, is better thought of as contrarian value investing.

Benjamin Graham, often called the father of value investing, introduced the idea of the manic-depressive Mr Market in his classic 1949 book The Intelligent Investor.

Graham’s Mr Market character would offer to buy and sell stocks every day at hugely variable prices. When manic, his enthusiasm for the shares meant he would offer to buy and sell at sky-high prices. But when depressed, the prices would be jaw-droppingly low.

Contrarian value investing is about buying stocks Mr Market feels unduly depressed about in the expectation the price will bounce back.

Sounds easy, in theory, right?

A key reason this is hard in practice comes down to what depresses Mr Market.

Why value Investing works

Mr Market was Graham’s metaphor for the stock market itself.

The stock market can be understood as the judgements of all investors that buy and sell shares. That means Mr Market gets depressed for the same reason any investor does: bad news, sour sentiment and falling share prices.

Being the buyer of shares in these kinds of circumstances is an endurance sport. It pushes against deep-rooted instincts of loss-aversion and self-preservation.

And when there is lots of bad news about a company, a sector, or even the entire economy, it’s very hard to imagine the often-unpredictable events that will change things.

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What is predictable, though, is something known as “reversion to the mean”.

Reversion to the mean describes a much-observed natural phenomena that when things go far in one direction, the chances increase that they will head back (revert) towards the historic average (the mean).

When it comes to listed companies, reversion to the mean can be seen in both their financial performance and how their shares are valued by the market.

That means investors that manage to buy shares in a troubled company before a recovery get the double whammy of improved financial performance, and Mr Market pricing up shares against those improving financials.

When it works

For value investing to work, investors need to have a reason to be worried about a company. It needs to be perceived as vulnerable.

It’s therefore unsurprising that historically, value investing has tended to do worst when the economy is in trouble and fears come home to roost.

But these are also the circumstances that create bargains. So, the flip side is that value investors often make huge gains during the early stages of economic and market recoveries.

How to measure value?

Historically, researchers have tested the effectiveness of value strategies by looking at what happens to buyers of shares in companies that appear cheap compared with the assets recorded on their balance sheets or their reported profits.

Today there are reasons to question the usefulness of these very popular valuation measures – usually referred to as price-to-book and price-to-earnings. The problem is that accounting standards have become outdated.

Mismatched accounting

Accounting is all about matching a company’s sales with the costs incurred to produced them. What’s left over is profit.

To achieve this matching, when a company invests in something that it expects to use to produce sales over several years, such as a van or factory, the spending is recorded on its balance sheet as an asset and then gradually matched as a cost against sales over its life.

However, some of the most important things modern companies invest in are intangible, such as brand, software code, and research into new products. Because paybacks on such investments are less certain than investments in traditional physical assets, these intangibles are largely treated by accountants as an upfront cost rather than an asset. This is despite the spending being intended to create sales far in the future.

So, companies that grow by investing in intangibles often look very expensive compared with their balance sheet (book value) because a large amount of what they invest is not recorded as assets. Their reported profits also get distorted because spending is not appropriately matched against sales.

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Several studies into the deteriorating performance of traditional value strategies have demonstrated this issue.

One study by an investment firm called Research Affiliates found that the outperformance a strategy of buying the cheapest shares based on price-to-book-value, and betting against the most expensive, between 1963 and 2020 improved from 3% a year to 4.3% when the estimated value of intangible assets was considered. And value’s chronic underperformance from 2007 to 2020 improved from -5.4% a year to -3.2%.

There are several ways of valuing companies that are unaffected by intangibles. My stock screen that beat the market by 242% during the darkest days for traditional value investing, uses one such method. Stock screens try to identify interesting shares based on a shopping list of financial characteristics.

We’ll find out more in a minute but first let’s touch on the biggest danger value investors face.

Value traps

Remember reversion to the mean?

The “mean” for a company can be thought of as its average profitability over a whole business cycle. This through-the-cycle profitability can change over time. For many reasons, particularly disruptive competition, previously good businesses can become unviable. If that happens, their shares are not worth buying at any price. They are a value trap.

There is almost always a reason for shares in a company to be cheap. Value investors try to find situations where those reasons are flimsy while avoiding shares that are cheap for good reason.

One important way to try to limit the potential for disaster is to avoid troubled companies with lots of debt, which can hasten a business’s demise.

Putting it all together

The screen I ran for Investors Chronicle magazine between 2011 and 2021 looks at the value of companies compared with their sales to identify cheap shares.

Because sales are recorded before any costs, they are not affected by the issue we’ve looked at with intangibles.

Sales-based valuation ratios have another advantage, too. Going back to the idea of reversion to the mean, companies are often at their cheapest when they are least profitable. Sales are far less volatile than profits over a business cycle, so provide a steadier target.

But companies that look cheap against sales are only going to be of interest if they’re able to produce decent profits in the future.

This is why my screen starts out not by looking for value, but looking for companies that have stable sales and have historically enjoyed decent profitability. The screen also checks debt is not too high.

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It’s only after companies pass this first set of tests that valuation becomes a consideration.

Stock screens are best used as a source of ideas for further research rather than to create off-the-shelf portfolios. However, it is testament to the screens’ ability to find worthwhile ideas that, based on annual reshuffles, it produced a total return of 380% in the 10 years to July 2021, or 270% after applying a notional 1.5% annual dealing charge. That compares with 88% from the FTSE All-Share.

Here’s the screen’s full criterial and the five FTSE All-Share stocks currently making the grade. My book Four Ways to Beat the Market, published by Harriman House, explains more about how this screen works, how to research the ideas it highlights, and how to adapt criteria to cope with changing market conditions. It also covers three other market-beating strategies.

Here’s what the screen looks for along with the FTSE All-Share stocks it is highlighting right now. I’ve also highlighted the test I feel are core to the screen while the others can be relaxed to try to achieve more results.

Step One

Companies must have:

• Average yearly sales growth during the last five years that’s among the top two-thirds of all stocks screened.
• Forecast sales growth in each of the next two years.
• An average five-year operating profit margin of at least 10%
• Positive free cash flow.
• Gearing (net debt as a percentage of net assets) of less than 50%, or net debt of less than two times earnings before interest tax depreciation and amortisation (Ebitda).

Step Two

Select the cheapest five stocks based on enterprise-value to sales (enterprise value is market capitalisation minus cash plus debt).

Source: FactSet data as 6 December 2023. Enterprise value-to-sales ratio, price/earnings ratio and dividend yield based on 12-month forecasts.

Algy Hall is an award-winning journalist and author of Four Ways to Beat the Market which can be bought by ii readers from all good book shops including Amazon.