I get this question a lot: How can I find a solid stock to buy that’s also a good value?
Investors want to know what they should buy (or avoid) as the bear market shakes out and eventually turns into a new bull market.
When the market is skyrocketing, stocks can become too expensive based on certain metrics.
When the market turns south, those companies start trading at more attractive prices.
But you have to look deeper than just the price of a stock when making an investment.
Today, I want to talk about value and show how our Stock Power Ratings system can help you avoid falling into “value traps.”
Value Stocks Remain Important Investments
When interest rates rise, investors start selling off growth stocks because their future earnings become less attractive against other investments that perform well in high-rate environments, such as bonds.
Value stocks are trading at much cheaper valuations compared to their growth peers after the decade-long bull market that ended in 2021. That, along with greater resistance to higher interest rates, and you can see why the market has shifted to value stocks.
The longer interest rates remain high — there’s a strong indication of another rate increase from the Federal Reserve next month — the greater the negative impact that has on growth stocks. All of that benefits value stocks.
The rationale for value investing is pretty simple: You buy a stock for less than its intrinsic value, then sell it later for a profit.
But there are a few problems with that:
- There isn’t a universal definition of “value.”
- Some stocks are cheap for a reason.
Oftentimes, when you seek out good value investments, you narrow your screening using one factor, such as the price-to-earnings (P/E) ratio.
This is a mistake because it can present you with what we call the “value trap.”
Value traps are stocks that appear cheap using standard value metrics like price-to ratios, but they don’t turn a profit (or even fall) because of underlying business fundamentals.
These are the stocks that are cheap for a reason, as I mentioned above.
Our Stock Power Ratings system can help you avoid those value traps and make smart value investing decisions.
Get Around the Value Traps
Value is one of the six factors that make up our proprietary Stock Power Ratings system. The other five are momentum, size, volatility, growth and quality.
These are six of the most widely used factors in the investing world.
Within the value factor are several subfactors such as (P/E), price-to-sales and price-to-cash flow.
All of that data gives us a value factor score on a scale of 1 to 100. The lower the stock’s valuation, the higher its value factor score.
As I said above, focusing on just one metric when screening for investments is not the best approach.
Remember, just because a stock looks like a good value based on price-to ratios, doesn’t mean it is.
You have to dig deeper.
It’s why the multifactor approach of the Stock Power Ratings system is so powerful.
For example, if I found a stock with a 99 score on our value factor, but a 45 on our quality factor, I would have concerns that I was looking at a potential value trap.
Our quality factor measures the profitability and balance sheet strength of a company.
A low score on the quality factor raises red flags about the company’s finances. It tells me the company is struggling.
Hence, that company would be a value trap — meaning it appears cheap because it is, and its future prospects don’t look great.
There isn’t a method for avoiding these value traps with 100% accuracy. But we can cut a huge number of potential traps by combining our value factor with other fundamental factors of our system.
This is especially important now as the bear market shakes out. Many stocks are trading at much lower valuations after last year’s massive sell-off. And some of these stocks are not going to hand investors the same returns they did during the last bull run.
Bottom line: If you see a stock that looks like a good value right now, check out its quality score in our Stock Power Ratings system to see if it has the profitability and balance sheet strength that will turn into future gains.
And on that note, my friend and inventor of the Stock Power Ratings system, Adam O’Dell, just revised his $5 Stocks to Watch report. His system plays a part in a brand-new strategy based on an arbitrary SEC rule that keeps institutional money away from stocks trading below $5.
He trimmed his initial list of close to 300 stocks down by cutting 171 tickers that are considered “High-Risk” within Stock Power Ratings.
Coming up this week, he’s going to issue a third revision to this report — trimming down the list to stocks with the greatest potential for the next year.
Make sure you check out this latest report. Plug some of those tickers in our Stock Power Ratings system and you’ll see the difference between a quality $5 stock and ones that are cheap for all the wrong reasons.
Stay Tuned: How to Spot Better Small Caps
Tomorrow, Adam is going to expand on what I’ve talked about today and show you why certain stocks made the cut on his $5 Stocks to Watch report.
You don’t want to miss it.
Matt Clark, CMSA®
Chief Research Analyst, Money & Markets