In order to obtain an investment result that will be above the average over a long period of time, there is a necessity of having a method of stock selection which incorporates two elements: (1) it must possess an objective or rational back-test; and (2) it must be different from the ones used by the vast majority of investors. My experience on this field leads me to consider three stock selection methods which meet them. They are different from each other and and each requires a different set of ability and psychology.
Blue chip companies
The market has a tendency to overvalue the stocks which have been exhibiting high growth whereas it undervalues the stocks that are out of favour due to adverse developments of a temporary nature. It constitutes one of the essential parts of the stock market dynamics and point to an investment approach which is relatively safe and promising.
The basic approach would be to concentrate upon the large companies undergoing an adverse period. The large companies have the resources in capital and in intellectual capacity to get out of the adverse situation and return to the normal earnings base; also, the market will most probably respond quickly to any improvement.
The idea of buying unpopular large companies on a group basis is quite simple. Nevertheless, when the individual companies are considered, another factor must be taken into consideration. During their good years, the companies have a tendency to sell at a high price and at a low P/E in the good years and the opposite in their bad years. In this case, the market has doubts over the perseverance of high profits in terms of valuation and the opposite when earnings are almost nil. Thus, one should start with a low P/E concept but must consider the issue together with qualitative and quantitative factors when constructing his portfolio.
Bargain companies
I define a bargain stock when it trades to less than its book value and thus is worth much more. In order to be definite on the matter, I may suggest that the stock is not a real bargain unless the current price of the stock is less than 50% of the book value.
One can value the stock by estimating future earnings and then multiply them by a factor, whether inherent to the company itself or to the market. If the obtained value is well above the current price, the stock can be considered as a bargain issue.
At the bottom of the market, a large section of the stocks can be very attractive in terms of price, measured by such standards. The current earnings and immediate future may be grim but the average future conditions may indicate intrinsic values that are well above the current levels. The only thing that one needs in depressed markets is courage and application of some basic valuation techniques.
The excesses of the stock market's behavior both on individual basis and on market basis permits the existence of many bargain issues at practically all levels. Therefore, there are two major sources of undervaluation: (1) short term unfavorable results and (2) general neglect. Nevertheless, on a stand alone basis, these cannot be considered as reliable methods for sound investment.
One should look for some sort of stability in the earnings over the past years with a sufficient size and financial strength in order to meet unfavorable events. The best combination could be a large company trading at a big discount to its past price and average P/E. This method may disregard many golden opportunities but I prefer real-profits compared to probable profits.
Stock selling below liquidation value
Sometimes, the stocks have a terrible beating in the market and they sell at big discounts relative to their book value. In such instances, the liquidation of the business itself would produce abnormal profits. All that the investor has to do is to estimate the relative fire-sale value of the company's assets and deduct all prior obligations. If the balance is positive compared to the stock price, the investor has a good bargain.
My experience with this type of investment selection had been very good for several years. I can affirm without any hesitation that this stock selection method constitutes a very safe and profitable method of determining undervalued situations and thus exploit them.
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