Value Stocks Are Back in Vogue. Here’s How to Find the Best of the Bunch.

By TradeSmith Editorial Staff

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From 2001 until roughly 2017, value stocks, such as those with low price-to-earnings ratios, outperformed the broader market, albeit slightly.

The chart below compares the percentage gains for the SPY S&P 500 ETF (orange) and the IVE S&P 500 Value ETF (blue) since 2001.

Source: TradingView

Yet, in 2017, value stocks began significantly underperforming the broader market.

This was a time when large-cap technology stocks boomed and the FAANG gang (Facebook, Apple, Amazon, Netflix, and Google) made every pundit’s list of stocks to buy. But the tech sector has been falling out of fashion in the last few months.

Value stocks are back in vogue. And it’s a trend I expect to continue for quite a while.

Let’s review an easy way to find value stocks by evaluating a company’s business and the metrics behind it.

Evaluating a Business and Management

Warren Buffett is famous for value investing.

He loves to buy companies with modest growth that generate cash while cultivating loyal customers or offering products and services people can’t live without.

Some of his favorite stocks over the years include Coca-Cola Co. (KO), Exxon Mobil Corp. (XOM), Hershey Co. (HSY), and Geico (now owned by Buffett’s holding company Berkshire Hathaway, BRK.A).

All of these companies run fairly straightforward businesses that are easy to understand and evaluate.

Compare those household names to conglomerates like General Electric (GE). Valuing a business with a lot of moving parts becomes extremely difficult. Plus, management can hide underperforming divisions.

Right now, regardless of the industry, companies should be focused on five key elements:

  • Reducing debt
  • Cutting expenses
  • Generating cash
  • Paying dividends or buying back shares
  • Fortifying their economic moat
Achieving these five goals is crucial to being a profitable business, which is what investors need to be looking for now. When the cost of borrowing rises, growth becomes a smaller focus.

That’s why we’re seeing companies like Uber Technologies Inc. (UBER) and Netflix Inc. (NFLX) cut their workforce.

Up to this point, they’ve been propped up by cheap debt and easy money. Now they need to show investors they can turn a profit.

At the same time, I don’t want to see a company sacrifice its vision. Effective management balances growth and profitability based on the current conditions. It strives for profitable growth.

Elon Musk’s Tesla Inc. (TSLA) is a great example of finding that equilibrium. The company invested in growth by launching its new Model Y in 2020, which became one of the top 20 best-selling vehicles in the U.S. last year and allowed Tesla to record its first profitable year in 2021.

Right now, I like profitable businesses in growth markets.

Most people, including myself, often assume this means technology. But as we mentioned earlier, the technology sector, once the shiny new thing, has started to lose its luster.

Yet commodity and energy stocks are in a massive boom cycle. And there are fewer players these days as a decade of low prices pushed out many of the weak hands.

We’re also seeing heavy demand for supply chain solutions including logistics and delivery, particularly for the last mile (the delivery of products from warehouses to consumers).

But just because these industries are flying high doesn’t mean all the companies within them are equally good investments. A bit of simple technical analysis can help you identify which businesses are pulling ahead of the pack.

Measuring Value

Everyone likes to talk about price-to-earnings (P/E) ratios when they speak about value.

I’m 50/50 on this metric.

P/E ratios work well for established companies that have consistent operations, including capital expenditures.

However, companies can, and have, manipulated earnings in the past. Just look at Enron.

But what they cannot manipulate are cash flows.

That’s why I prefer to look at the cash generated by the company from operations and after capital expenditures, known as free cash flow.

The main metric I look at is the price-to-free cash flow ratio. I will look at the price-to-operating cash flow ratio if there was an extraordinary capital expenditure that skews the data.

Note: Not all platforms will tell you whether they are displaying price to free cash flow or operating cash flow. Some places will also display the price to forward cash flows as well.

A good example of a stock with a fantastic price-to-free cash flow ratio is U.S. Steel (X).

For example, the price-to-free cash flow ratio over the past 12 consecutive months is 1.87x, as of May 25.

Let me put the 1.87x price to free cash flow in perspective.

At the current rate, U.S. Steel generates enough cash in 1.87 years to buy back all of its current stock.

That’s truly a mind-blowing number.

And it’s a big reason why investors, who now see their opportunity costs rising from higher interest rates, are rotating cash into commodity and energy stocks.

Because even if the Fed halts inflation, that doesn’t mean that the price of steel or oil necessarily drops.

So it’s reasonable to think that U.S. Steel could generate enough cash to pay for all its outstanding shares in a couple of years.

Pick Your Spots

With market volatility at some of the most extreme levels we’ve seen since the pandemic, it’s more important than ever to be patient and wait for opportunities to find you; don’t try to force something into becoming an opportunity.

I may have my eye on dozens of stocks, but until I get a clear signal from TradeSmith that the stock’s health has changed, I’m not interested. The reason is simple.

It’s almost impossible for anyone to call the top or the bottom of a market, and we need to let tools and systems help identify when to make our moves.

Do you have any stocks you’d like us to analyze to see if they pass the value test? Let me know here.