As you've no doubt heard by now, Warren Buffett recently gave billions of his fortune to the Bill & Melinda Gates Foundation. How did he manage to create that much wealth in his lifetime? By bargain-hunting.
Buffett is known as a value investor, which means he buys stocks that he thinks are undervalued, or cheap, relative to what they are worth. Maybe a particular industry is being hammered in the press and the stock price of every company in that industry has dropped. Or possibly a management scandal has caused the stock price to plummet. If Buffett, or other value investors, suspect the price has fallen too far too fast, they buy the stock, betting on an eventual increase.
It is a method of investing that has worked well for some time. So well, in fact, that some experts are now pointing out that value stocks — as a group — are starting to look fairly expensive. "All of a sudden, because prices of these traditionally value stocks have been going up, they are not looking like such values anymore," says J. Bryant Evans, a portfolio manager at Cozad Asset Management in Champaign, Ill.
Indeed, at the end of May the price/earnings ratio on the Standard & Poor's 500/Citigroup Value index was 15.4. That's loftier than typical. "In general it may be true that value is getting a little expensive and may not be such a great value anymore," says Evans. "But there are always individual stocks that you can find that are value." In this market, in particular, you just need a little more strategic thinking in order to find value stocks:
Consider
Can good management fix the problem? "The first thing Evans considers when searching for deep value companies, which are extremely undervalued, is whether or not the company has faced a similar problem before, and if so, how the management team dealt with it. For example, maybe a bank is reporting lower earnings today because the spread between the interest rates it earns and charges has narrowed. Has the company experienced this situation before? How did it deal with the problem? Did it eventually rebound? Do the same, or equally qualified, leaders run the company today? If the problem is short-term, a good management team will likely be able to eventually increase the stock price. But if a company has enjoyed great success because of a patented invention and now competitors have discovered an even better technology, the company may never rebound. Evans says that too often investors do not spend enough time evaluating a company's management.
Stick with 'em
The prices of value stocks have increased largely because they have outperformed growth stocks for a number of years now. From May 31, 2005 to 2006, the S&P 500/Citibank Growth index returned slightly more than two percent, while the value index returned over 15 percent. "Value is popular now because it has done well," says Harold Evensky, a certified financial planner and the chairman of Evensky & Katz in Coral Gables, Fla. "There are times it won't be so good. So people shouldn't be in it simply because it has done well recently." There are periods when growth stocks perform better than value. (Think about the 90s. Some experts predict we're now heading into another period.)
So the key is to remember that you're not moving into value to chase the latest hot investment. You're moving in because your portfolio needs both growth and value, just like it needs both domestic and international. Traditionally, over the long run, value stocks outperform growth. If you stick with them, the research shows your loyalty should pay off.
Diversify
If you plan to invest in individual value stocks, you need to invest in a dozen or more in different industries, recommends Evensky. You face high risk with individual value stocks because the companies are weak. There are reasons, after all, why many of these companies remain at low prices. While one company may overcome its problems and thereby increase its stock price, it also may go bankrupt and drop to next to nothing. So you will decrease your risk by spreading your money across a variety of companies and industries.
If you have less than $300,000 to invest, Evans suggests sticking with mutual funds that invest in value stocks. If you're determined to go the individual stock route and don't have that large a chunk of change — few people do — try putting a few thousand dollars into a different value stock every six months. In five years, you'll own your 10 stocks.
Analyze the ratios
One of the biggest mistakes investors (not just value investors, but all investors) make is to chase past performance. Rather than looking at previous price movements, investors need to crunch the numbers to predict future movements.
A value stock is traditionally defined by a high dividend yield or a low price-to-earnings or price-to-book ratio, which vary depending on the industry. Use an index such as the S&P 500 as a benchmark and look for these ratios to fall in the bottom third. Also, Evans recommends looking for companies that are not carrying too much debt, meaning a debt-to-equity-ratio below 35 percent. You can find these statistics on financial Web sites such as finance.yahoo.com.
Jean Chatzky is an editor-at-large at Money magazine and serves as AOL's official Money Coach. She is the personal finance editor for NBC's "Today Show" and is also a columnist for Life magazine. She is the author of four books, including "Pay It Down! From Debt to Wealth on $10 a Day" (Portfolio, 2004). To find out more, visit her Web site, .