Value Investing "Rules" That Work, and 1 (Potentially) Great Stock Pick

Adem is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Value investing rule #1: never fall in love with a stock—period.

Separating “money” decisions from emotion is hard. That’s why new value investors need to establish “buy rules” and adhere to them.

“Buy Rules” That Work

1). Start with the numbers

Numbers weed out bad stocks before you have the chance to fall in love.

Go “simple” with metrics. People who preach about “discounted cash flow” models just like to hear themselves talk. You can get similar results with metrics that are easier to understand and follow.

Let’s Keep This Simple:

High ROA: This is the best metric you can follow to find quality businesses. ROA measures the return from every dollar put in and will lead you to many companies with great cash flow. Companies with high ROA typically have an “edge” and grow without over expanding or taking huge risks.

 +

Low P/E: buying earnings cheap.

=quality, fairly valued business. Thanks Joel Greenblatt!

Let’s Walk Through an “Example” screener:

Company P/E ROA
Herbalife (NYSE: HLF) 11.9 30.91%
Travelzoo (NASDAQ: TZOO) 14 26.41%
Apple  (NASDAQ: AAPL) 11 28%

3 good stocks (by the numbers) but are they worth buying?

2). Develop a thesis

Develop a “thesis” not a “story,” that means objectively searching for tenants that every value investment must have.

A Backstop

Make sure the business can’t go bankrupt. When you take that off the table the risk drops precipitously and the chance for success increases.

Apple: negative sentiment has surrounded this stock since Steve Jobs passed, but it’s nearly improbable to think it would go out of business due its scale and the “stickiness” (i.e. relationship between iPod/iTunes). Further, despite its rapid price decline it has increased cash flow and revenues over the past year all while initiating a dividend.

Dividend + strong cash position + growing revenues = margin of safety exemplified

Travelzoo: I hate that Travelzoo’s business has a very low barrier to entry. However, it has a great ROA so it must be offering something competitors aren’t. I’m not saying “stay away;” just make sure you can explain its “edge” before you buy.

Herbalife: This is probably unfair, but Herbalife has to have the least “backstop” of the bunch. The company actually has great numbers, but they’re being disputed. Right or wrong, holding a “battleground” stock is a huge risk.

B). Catalysts

All of these stocks actually have a catalyst depending on how you look at it. Travelzoo and Herbalife are high risk/high reward situations:

If Bill Ackman is wrong, HLF will rally hard. That’s a big “if” but, while speculative—that could be a huge catalyst. However, there are too many safer places to make money right now—I’m passing.

Travelzoo’s less risky; the stock is low because last quarter’s earnings trailed the previous years. But this company's earnings are very erratic. Q2 showed a 50% gain over FY 2011 and analysts typically get Travelzoo wrong. If you really believe in this company, it’s safe to say that the next quarter’s estimates have a 50/50 chance of being “too conservative” in which case the stock should rally. Plus, Travelzoo is a (relatively) fast growing small cap in a “cash rich” industry so there is always a possibility of a buy-out. Speculative catalysts are still potential catalysts.

But it’s Apple, again, that really takes the cake. Not because I’m predicting that it’s going to sell “x number of xyz product,” but because the negative sentiment surrounding this stock has become comically baseless. Apple has fallen 40% this year just on headlines! Analysts are wrong half the time, which tells us this stock might just be a great value.

Take this downgrade from a Citi analyst based on iPhone 5 sales “worries.” The next day, Apple reported record sales for the iPhone 5 in China. Apple could flop from here, but it’s time to re-examine the gravity we place in analyst downgrades.

This analyst initiated Apple at a “buy” 20 days prior to his downgrade, with a price target of $675! What did he seriously see in less than a month that had materially changed in Apple’s business model for the long term? Nothing—in both cases he wanted to be “right.”

With Apple trading at 11 x earnings and 7 x forward earnings (less than Microsoft?!) it doesn’t need hyper growth to rally; it just needs to “not die.”

It might take a while for the market to realize it, but that is a catalyst worth betting on; there are no “juggernauts” of tech right now that can kill Apple.

I’m not telling you to buy Apple

Sure, I think that with its catalyst (just don’t die!) and margin of safety Apple is the best pick of this bunch and not a bad stock in general, but I’m not saying to rush out and buy it today.

Rather, you should make and follow a similar “rules based” strategy that starts with numbers and aims to divorce you from biases.

Will you end up with Apple? I don’t know; I just know you’ll be a step closer to making real money—period.

 




Adem Tahiri has no position in any stocks mentioned. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple and has the following options: Long Jan 2014 $50 Calls on Herbalife Ltd.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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