How to Pick Value Stocks like a Hedge Fund
Posted on February 23, 2018
Equities have been firmer, the US dollar index is off the low, and gold doesn’t look so precarious now that its come in a little following the negative RSI divergence that had appeared on the daily chart. Most importantly of all, the VIX is back below 20 following its recent explosion above the 50 level. So its been a much calmer week, which has allowed us to take a fresh look at some longer term stock ideas in our newly available Trading Club meeting.
And thats the theme of what I want to share with you all today, in place of our usual Q&A. Its very easy to get caught up in the emotion and noise of trading, and even with our Checklist process it can still be psychologically and physically demanding. As much as we love volatility (read, opportunity!), one of the most powerful things you can harness to grow your long term wealth is the effect of compound returns over time.
With this in mind, I wanted to share some of the techniques that we featured in this week’s Trading Club video showing how Lex and I apply bottom-up fundamental analysis to stock idea generation as value investors (out of respect for our paying members, we will only feature a small selection of everything you can access in this week’s video with a premium subscription). In the video, we screen the 1,000 stocks that make up the Bloomberg Europe 500 Index the S&P 500 Index. We go through each sector systematically, applying the fundamental criteria that we are looking at to identify areas of value.
Here you can see an example of the S&P 500 Consumer Discretionary sector, with the various columns capturing everything from relative value to relative strength, momentum and stock specific fundamentals (P/E, P/S, P/B, EV/EBITDA etc). Without wishing to bombard you with the full level of detail that I provide in the video, the simplest way to identify potential candidates for further research is to look for the green highlights (the more green, the more value!).
Now, the first two columns are arguable the most important from a fundamental perspective. If they are highlighted, then it indicates that the stock is selling at a substantial discount to the market, its long-term valuation range, or both. You will notice that Discovery Communications (DISCA) matches both criteria, and a few others including BorgWarner (BWA), CBS Corp (CBS), Ford (F), Footlocker (FL), General Motors (GM), Goodyear Tires (GT), Hanesbrands (HBI) and H&R Block (HRB) are partial matches.
Now, its all well and good being fundamentally ‘cheap’, but as the saying goes, "what is cheap today, might be even cheaper tomorrow.” So to help avoid 'catching falling knives’, we also want to see columns 3 & 4 green, which indicates positive relative strength in the price action (and suggests interest amongst deep value investors). At the bottom of the next image, you can see homebuilder Lennar (LEN) which shows both fundamental value, and technical relative strength.
In the case of Lennar, its probably worth having on your watchlist for further research. But there currently isn’t a great deal that gets me excited in the consumer sector as from a contrarian value perspective. Healthcare, on the other hand, has been my main area of focus for the past couple of years and there have been some great trading opportunities realised from this type of research recently. (Again, out of consideration for our paying members I won’t be reveal any more names beyond this next one, but there are plenty more in the video).
In this example we see Express Scripts (ESRX), which I have been tracking for some time. The first two sections on the left are green, but what I want to draw your attention to is all the green in the columns on the right hand side of the page - they would make The Incredible Hulk look anaemic! What this tells us is that the stock is fundamentally undervalued across several measures (not just the P/E) relative to the sector and its own historical valuation range. This is how we generate ideas for further research using our Company Analysis Checklist, which is based on the illustration below.
So thats how we build a diversified portfolio of value stocks providing a margin of safety that would make Warren Buffett and Benjamin Graham proud, and provide conviction to weather the inevitable volatility that the equity investors face, particularly when passively invested in index ETFs.
Thats all for this week, but if you would like to learn more about our approach you can access this week’s video along with an archive including all the rest over the past 3 months by becoming a member of our Trading Club today. I hope you can join me there!
Do keep your questions coming next week if there is anything you would like to ask me. And of course, if you haven’t already, there is no time like the present to take the step up in your education and join us here by taking the Million Dollar Traders course or Trading Club membership (you can also contact us at [email protected] to learn about available discounts and promotions).
Have a great weekend,
James Helliwell | Chief Investment Strategist
Disclaimer: Our service is intended for educational and informational purposes only and should not be considered investment advice. Do not make any decisions based on the articles and material presented on www.lexvandam.com and never trade with money you cannot afford to lose. We cannot be held responsible for your trading results. For more information, please check Risk Disclosure - T&C.