A look into the mind of how a value investor works through the process will help you to develop a deeper understanding of what is involved in this approach to investment.

By following a predefined value investment guide you will learn how to identify great opportunities based on the skill of where to look and on how to conduct and decipher fundamental analysis. Whilst this may sound like a technical process, value investors can follow a defined criteria as they zone in on an opportunity that conforms to the principles of value investing. .

Sector specific stock screening process

Objective - Generate sector specific ideas to conduct fundamental analysis on 20 companies.

Begin with your focus on a specific industry sector. For example, as part of your diversification strategy you would like to include a Pharmaceuticals stock to your portfolio. Using any one of the free stock screeners (Google Finance, Yahoo Finance), filter through to your chosen sector to begin looking for signs of attractive valuations.

Identifying attractive valuations will require you to look into the basic financial structure of companies. As value investors we are looking for cheap valuations in great companies. To determine this in your chosen sector, begin by assessing companies under the following criteria;

Return on Equity greater than 12% Debt-to-Equity less than 0.5 Current Ratio greater than 2
A sign that the company is profitable and has the potential to demonstrate a competitive advantage Indicates that the company is able to fuel growth through cash generated as a result of operations Positions the company's capital structure with the ability to meet its short-term obligations

Whilst this list may exclude some of the more common investment analysis metrics such as the Price/Earnings ration, they provide you with a snap shot of how efficient management is in operating the business.

Value driven companies are profitable (check #1), they are able to generate significant cash-flow from operations to fuel growth and expansion (check #2), and they are financially capable of paying for short-term liabilities such as debt or lease renewals etc.

So after you have focused on a sector, filtered out the stocks that do not conform to the three criteria above, you should now be able to take 20 or so candidates onto the next stage of analysis.

Candidates for a value driven investment

Objective - Filter your selection down to 2-3 great companies.

Now that you gathered together about 20 candidates you are ready to filter through the rubbish in pursuit of 2-3 really solid value driven companies. You will now need to take your initial sector specific stock screening process and dig further into each of your 20 companies to see if they are able to match your value investment criteria.

To do this your research should focus on the recent shareholder information section of corporate websites, paying specific attention to the most recent financial statements and management's letters to shareholders.

Here you find the true fact about how a company is operating, whether it is and has always been successful, if it's competitive advantage is stable, if profits are utilized efficiently and amongst many other things, whether the company's financials are attractive to a value investor such as yourself.

Here are the key metrics to look out for;

  • History of high profitability
    The ability of a company to demonstrate previous profits that have increased over time shows you that management's efficiency is improving and/or that the company's products or services are marketed effectively to facilitate price increases without affecting market share.
  • Low dependence on debt
    Whilst the ability to turn debt into profit is considered a competitive advantage, a value driven company must be able to fund operations through it's business activities. A heavy reliance on debt raises the question as to how the company would react during a turn in the wider economy or as interest rates rise.
    Be wary of a company that has a debt-to-equity-ratio great than 0.5 and whose current ratio falls below 2. This would indicate an over reliance on debt positioning the company in murky waters.
  • Unparalleled competitive advantage
    Unfortunately numbers alone cannot tell the whole story here. As you become a more accomplished value investors you will begin to get a better feeling for what makes a competitive advantage sustainable.
    Take a look at the 'Managers discussion and analysis' section of the financial statements to get a feel of what has made a company competitive and whether that advantage is likely to stay strong.
    Indicators of a sustainable competitive advantage include;
    • Patents
    • Trademarks
    • Manufacturing capabilities
    • Network and logistics
    • Marketing efficiencies
    • R&D commitment
  • Exceptional management teams Management's ability to develop and execute business strategy is essential to maintaining its position as a sector leader. Taking an existing competitive advantage and adapting it to align with evolving consumer preferences is a skill that a competent management team must possess.
    Take the Blackberry company as an example. The phone development and manufacturing company once held a significant competitive advantage in the smart phone sector. In April 2008 their stock was priced at $138.87 per share. Today the stock is worth just $7.56 and the company is lucky to still be in business.
    Management's inability to react to the competition from Apple's iPhone, and to meet the evolving demands of it's one time loyal client base, sent the company towards bankruptcy. A shocking and very costly experience for investors caught up in the company's decline.
  • Management's responsibility to shareholders A good sign of a responsible management team, and one that MUST be part of your value investment selection process is it's attitude towards shareholder dividend policy.
    So far we have seen that to meet the value investment criteria a company must be profitable without the reliance on debt, and whose management is able to sustain it's existing competitive advantage.
    If a company under your scrutiny is able to check all these boxes, then there is a good chance that the company generate substantial cash with a high rate of return on equity. If this is the case, then look to see how management deals with the excess cash.
    Does it offer a consistent, above average dividend to shareholders? Does management prefer share buy back options? Either of these factors would be a great sign as you move onto the next section of your analytical quest.
  • Understanding your investment Investing your capital into a business that you do not understand is as good as speculating on penny stocks. Whilst you may understand the financial of a company, unless you have some knowledge on the product, service and competing industry you are unable to make informed decisions as and when markets forces inevitably come into play.

You began this section of your analysis with 20 or so potential candidates. Researching each of those 20 company can be a time consuming process. With this in mind it is important to remember that the work you do now will likely pay dividends for many years to come.

You are not only investing your capital for the future, but you are also investing your time. If it takes you a full day to analyze one company and that company turns out to be a winner, you will be glad to have put in the effort.

Also consider that not every one of the 20 candidates will require a full in depth analysis. You will begin with one company and see that the first criteria 'History of high profitability' does not apply. In this case the investment does not conform to the value philosophy and therefore can be left alone as you move onto the next candidate.

Slow, steady and articulate wins the race for the value investor.

Right price and intrinsic values

At this stage you have 2-3 great companies, each of which you could include into your portfolio now and be sure of an acceptable return. However to be sure that your efforts are rewarded, you want to zone in on the best of the best to maximize your long-term returns.

Identify the company whose intrinsic value is most attractive is final step of your selection process. By acquiring the stock at a value lower than its fair market price is where you build you long-term profits under a margin of safety.

Again, just like a competitive advantage, there is no steadfast formulae to determine the intrinsic value of a company. Your criteria checklist will help to identify great companies, but your intuition will the factor in selecting the best value driven investment based on price.

To give you some form of clarity, use the following criteria as you develop a gut feeling for the right stock at the right price;

  • Price-to-earnings multiple
    Giving you a five year performance forecast based on the historical price-to-earnings performance valuation to present a reasonable net present value of the stock
  • Discounted cash flow
    A key metric that helps you to determine the value of future cash withdrawals in consideration of an expected time scale.
  • Return on equity
    A favourite of the world's most proficient value investor, Warren Buffett. The metric delivers a forecast of management's efficiency to generate significant returns from operations

Final thoughts

By using the above metrics in compression with the trading price of the stock you will see whether the stock is below its intrinsic value, that is its fair market value.

If you find that the price is below its intrinsic value, then you have successfully uncovered a gem that will furnish your portfolio with profits for years to come.

If however you feel that the stock is trading at a price that is too close to its intrinsic value, then you should add the stock to your watch list in anticipation of the price becoming more favourable in time.

By following this value investment guide you follow a process that is used by the world's most successful value investors. Coming across value driven investments can take time and effort, however once you uncover the potential of your first value investment and experience its benefits, you will be willing to continue your pursuit of perfecting the value investment philosophy.