Basic Guidelines for Identifying Value in Stocks

For the naturally curious among you, here are some basic rules I use for identifying value in stocks.

First, I will look at what is going on in the broader market. Do I see a turning point because the market is 'oversold' or 'overbought', when prices have fallen (or risen) more quickly than fundamental or technical analysis would otherwise suggest? Is there an index rebalancing going on?

What is happening within the company's sector? Has the story in the space been under- or over-reported by the media? Has there been M&A (merger and acquisition) activity?

Of course, valuations have to be considered. I like to look at both trailing and forward P/E (price/earnings) ratios. On top of that, I find price-to-book (assuming of course we can ascertain the value of the actual book!) and PEG (price/earnings-to-growth) ratios to be very helpful.

Does the company have pricing power? If so, how sustainable is that power? What event could occur that would damage pricing power? For example, steel has recently enjoyed tremendous pricing power in the midst of a modest global slowdown - a very powerful indicator.

Market technicals always need to be examined. I like to look at trend lines, but I also closely monitor the 50- and 200-day moving averages and how closely the stock is trading to those levels. Used in a vacuum, technicals can be very dangerous, but used in accord with fundamentals, technical indicators prove to be very helpful.

Short interest is another metric I monitor. Is the stock at an 'inflection point' and poised for a short covering rally? (Reminder: short selling is the practice of borrowing shares and immediately selling them, in expectation that the stock will decline and can be bought back more cheaply.) Has the short interest in the stock been growing and what has been the price action of the stock during that time?

Is there a repurchase plan in place? What percentage of the market capitalization of the company does the firm plan to buy back? Of greater importance, what is the time horizon for the buyback? Is the company buying back stock by issuing more debt, or are they using cash from a healthy balance sheet?

Are insiders buying or selling? Historically, what type of indicator has that been for the price action of the stock? Is the selling part of a previously announced plan, or did it 'come out of left field'?

Another item I pay very close attention to is institutional ownership of the stock. What are the smart people in the hedge fund world up to? Some large hedge funds do not have holdings in a lot of names, but what they do own they usually own a lot of. That is a very strong indicator for me.

Management: I want to know who is running the place. Continuity is very important. How long has the management team been in place? How well does management tell their story to Wall Street? Some companies do a great job of 'managing' Wall Street's expectations. There are rarely any negative surprises.

None of these guidelines work well if used on their own. When used in combination, however, these can be extraordinarily powerful tools!

--Guy Adami

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