Special Report: The Value Road to Wealth

	Paul Tracy Street Authority.com
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With high oil prices, rising interest rates and slowing economic growth as a backdrop, my staff and I feel the broader market is likely to trade flat-to-lower in the coming months. In this type of uncertain overall market environment, value-oriented stocks should handily outperform their peers.

With this in mind, in today's issue my staff and I will depart from our standard newsletter format in order to bring you a special in-depth research report on value-oriented stocks. In this new report, entitled "The Value Road to Wealth," we'll provide undeniable proof that value investing outperforms growth investing over the long haul. We'll also show you what to look for in a good value stock and will introduce you to several quality firms that should make excellent value investments in the months and years ahead.

We sincerely hope you enjoy today's Special Feature Issue, and good investing in the week ahead!

The Value Road to Wealth
Have you ever sat back and tried to compile a list of the most successful investors of all time? If you're like most investors, then during that process you probably considered such names as Warren Buffett, Benjamin Graham, Peter Lynch or John Neff.

While all of these great investors certainly had distinct approaches to the market, they had one thing in common: They are all considered -- to one degree or another -- to be value investors. 

While momentum investors come and go and this year's hot mutual fund manager fades into next year's chump, value investors like Buffett and Lynch have shown incredible staying power over the course of their careers. While all of these great men certainly went through some cold streaks on the investing front, we cannot think of another approach that has proven to be more effective or reliable than value investing over the long haul.

A wealth of academic research has been published on this very subject, offering us some cold hard facts to back up this assertion. For example, according research firm Ibbotson Associates, from December 1968 until December 2002, value stocks delivered an average annual return of +11.0%. By comparison, growth stocks returned +8.8% and the S&P 500 managed a mere +6.5% annualized return.

The Russell Investment Group provides us with another great example. That firm's widely followed Russell 2000 Index is also divided into two sub-indices based on a host of fundamental criteria -- a Russell 2000 Growth and a Russell 2000 Value Index. In our chart, we've depicted the growth of two $10,000 investments from mid-1995 through the end of the first quarter of 2005; the first $10,000 was invested in the Russell Growth Index and the second in the Russell Value Index.

What's clear is that for almost this entire period the Russell 2000 Value Index firmly outpaced the Growth Index. This was the case for all but a few months surrounding the year 2000 top.

What's more, contrary to popular belief, our chart shows that value stocks still delivered strong gains during the bull market of the late 1990s. And as we would certainly expect, value stocks handily outperformed growth stocks throughout the bear market of 2000 to 2002. (During times of economic uncertainty, investors traditionally flock to quality value stocks for the safety and stability they provide.)

This is a perfect example of why focusing on value makes sense for most investors. Hot momentum and growth stocks may come and go, but over the long run value consistently wins out.

What is Value?

Before we go any further, we first need to get a better understanding for what we mean when we use the term "value." In order to grasp this important concept, we need to first take a step back and look at what we're actually buying when we purchase a stock.

Some investors buy stocks because they offer compelling and enticing stories -- a new potential blockbuster drug, an emerging technology or an exciting new invention, perhaps. Meanwhile, others purchase stocks primarily based on the value of their assets. However, when you purchase a stock, it's important to remember that you're not buying a story, a manufacturing plant or a bunch of equipment. At its very core, every stock investment simply involves the purchase of a stream of future cash flows.

Stocks represent nothing more than an ownership stake in the cash flows that a particular company will earn in the future. It's cash that ultimately allows companies to declare and pay dividends or buy back stock. Although this cash can sometimes come from the sale of important assets (or the entire business itself), it primarily comes from a firm's operating activities. With this in mind, a hot momentum stock may have a great story to tell, but ultimately that story will prove meaningless if it doesn't lead to the generation of solid annual cash flows.

Sure, from time to time these growth-oriented plays eventually blossom into cash-generating machines. Microsoft provides us with an excellent example of this. Over the past several decades the software maker has transformed itself from a promising young upstart to a mature corporate giant that generates roughly $15 billion in annual operating cash flows.

However, for every hot growth/momentum stock like Microsoft that ultimately blossoms into a highly-profitable bellwether, there are countless others that fall into obscurity and deliver nothing but heartache for investors. Even worse, as we saw all too often following the dot-com boom in the late 1990s, some of these companies can even end up in bankruptcy.

Value investing isn't about purchasing stories -- it's about buying stable companies with proven business models that generate consistent annual cash flows. In addition, value investing is all about buying these stocks for less than they're actually worth. In other words, value investors look for situations where the future stream of cash flows a company is likely to produce -- which is closely related to the stock's intrinsic value -- has been mispriced by the market.

Most value investors also use the important concept of margin of safety when evaluating investments. In doing so, they first use a variety of techniques to estimate the true intrinsic value of several different companies. They then invest exclusively in those firms that are trading at a sizable discount to their estimated intrinsic value. By investing in this manner, even if their estimates of a company's actual value prove to be slightly incorrect, they should still manage to earn above-average returns.

Warren Buffett offers myriad examples of this methodology in action. One such situation was Buffett's 2003 purchase of Clayton Homes, a manufactured homebuilder.

Prior to the acquisition, Buffett believed that the market was undervaluing Clayton due to the volatile history of the manufactured housing industry. More specifically, manufactured housing companies tended to get overly aggressive when lending to consumers during booms in the real estate market. When the market slowed, these companies would then face tough times when many of those ill-advised loans went bad. When Buffett picked up Clayton, the Fed was preparing to raise interest rates and many investors on Wall Street felt the boom-and-bust cycle was about to repeat itself again. Conventional wisdom at the time said that manufactured homebuilders would get stuck holding a bag full of bad loans.

But Buffett knew Clayton was an extremely well-run company. In sharp contrast to many other firms in the industry, Clayton's management prided itself on being conservative in its lending practices. The company tended to seek out higher-quality customers who wouldn't default when times were bad.

In this case, Buffett managed to uncover a stellar value investment because the market had mispriced Clayton. Wall Street had painted Clayton with the same brush as the rest of the industry despite the fact that the company was far more conservative and less vulnerable to rising interest rates. To make a long story short: Buffett's assessment of Clayton's value was right on target, and as a result, he managed to earn tremendous returns by purchasing Clayton Homes at a steep discount to that value.

What Tools Can Investors Use to Discover Quality Value Stocks?

Value investing is not easy. It's difficult to estimate the true intrinsic value of a firm, and in the example above, Buffett undoubtedly put months of research into uncovering the Clayton story. There is no one magic bullet, no single metric that will allow investors to uncover the best value plays quarter after quarter. However, my staff and I take a number of factors into consideration when looking for good value candidates. Here are just a few of our favorites:

Price-to-Earnings (P/E)
Ask most investors to define value investing and they'll likely mention P/E ratios. This widely used ratio provides us with an important measure of a company's stock price in relation to its earnings. As most investors know, you can calculate a firm's P/E ratio by dividing its current stock price by its EPS (earnings per share). The result essentially indicates how much investors are willing to pay for each dollar of a particular company's earnings. All other things being equal, the lower a firm's P/E ratio, the better value the stock is relative to its current earnings base.

There are many ways to measure P/E ratios. Some investors like to look at trailing numbers -- these are based on the company's actual earnings performance over the trailing 12-month period. Meanwhile, others prefer to look at forward P/Es, which are based on analysts' estimates for the year ahead (or even further in the future). My staff and I prefer to examine both trailing and forward values. Although stocks are valued primarily on expected future cash flows (not past performance), historical values can still prove to be quite useful. If, for example, a company's forward P/E is well below its trailing P/E level, then this may prove to be a warning sign that analysts are overly optimistic about the firm's future.

It's also important to remember that P/E's are meaningless when examined in isolation. In some cases a company with a P/E of 20 might be overvalued, but in other cases it could potentially be undervalued. For example, a particular stock might trade at a P/E of 20, but if the firm is posting reliable earnings growth of +50% per year, then this stock could make a much better investment than a company with negative growth that's selling for 10 times earnings. This is true even though the second stock looks "cheaper" on a pure P/E basis.

P/E-to-Growth (PEG)
By incorporating a firm's expected future growth into the equation, PEG ratios help us to eliminate one of the major shortfalls of pure P/E comparisons. PEG ratios can be calculated by dividing a company's P/E by the firm's long-term estimated annual growth rate. For example, a company with a P/E of 15 and projected growth of +20% per year would have a PEG of 0.75 (15/20 = 0.75). As a simple rule of thumb, stocks that sport PEGs of less than 1.0 are considered to be relatively decent values.

Although the PEG ratio is an extremely useful measure, it's far from foolproof.. Very high-growth companies can often sport PEGs over 1.0, yet still be decent long-term values. And don't fall into the trap of believing that all companies with PEGs under 1.0 are good investments. After all, poor or unreliable growth estimates can easily throw off the calculation. With these potential pitfalls in mind, when looking for a quality value stock, investors need to consider a number of other factors in addition to PEG ratios. (Since no perfect financial indicator exists, the same could be said of all other ratios.)

Enterprise Value/Cash Flow
As we explained above, a company is worth only the sum of the future cash flows it can generate from its business (or from the sale of its assets). With this in mind, value-conscious investors should always examine a firm's cash flows before making any investment.

Cash flow measures the actual money paid out or received by a company over a certain period of time. This measure excludes non-cash accounting charges like depreciation. And, more importantly, cash flows are objective. There is no value judgment about when and how revenues are recognized -- the cash flow statement only recognizes the actual cash that flows into or out of a business. My staff and I focus particular attention on operating cash flow when evaluating a company. Operating cash flow excludes extraordinary items and loan proceeds from the cash flow equation.

But it makes little sense to simply look at cash flows in isolation. Always mindful of valuation levels, my staff and I like to compare a company's operating cash flow to its enterprise value. This gives us a better sense for the amount of cash a company is generating each year relative to the total value (both debt and equity) investors have assigned to the firm.

For those of you unfamiliar with the term, enterprise value (EV) is a way of adjusting market capitalization to more accurately reflect a firm's true value. EV is calculated by taking a company's market capitalization (price per share times the number of shares outstanding), then adding debt and subtracting the firm's cash balance. This makes EV an excellent reflection of the total value an investor would receive if he/she purchased the entire firm -- the investor would have to pay off a firm's debt but would get to keep the cash on the books.

By dividing a company's operating cash flow by its enterprise value, we're able to calculate the firm's operating cash flow yield (OCF Yield). As we noted earlier, this measure reflects how much cash a company generates annually compared to the total value investors have placed on the firm. All things being equal, the higher this ratio, the more cash a company generates for its investors. Companies with high OCF yields are much more likely to end up being excellent value stocks.

Price/Sales (P/S)
P/S ratios are similar to P/E ratios. The difference is that instead of dividing a firm's share price by its earnings per share, the P/S ratio is calculated by dividing price by sales per share. As a general rule of thumb, companies with P/S ratios of 2.5 or less tend to be fairly reasonably valued. Once again, however, that's just a quick rule of thumb. In practice, a host of other items -- including growth rates and industry norms -- must be taken into consideration.

As we mentioned earlier, the P/E ratio is by no means a perfect measure. A firm's net income is merely an accounting entry, and as such, it often includes a host of non-cash charges like depreciation. Also, companies can use a variety of accounting tricks to manipulate their earnings from quarter to quarter.

Revenue numbers are much harder for a firm's accountants to manipulate. With this in mind, it's a good idea to look at P/S ratios in combination with measures like P/E and PEG. If P/S and P/E give different pictures of a company's valuation, then it's worth taking a second look at any special charges or gains recorded on the company's profit and loss accounts. This will give you a much better sense for how the company is performing, where its earnings are coming from, and whether the stock is reasonably valued.

Return-on-Equity (ROE)
ROE provides investors with another excellent tool to help uncover value stocks. The calculation of ROE is simple: divide a company's net income -- defined as total profits after interest, taxes and depreciation -- by its shareholder's equity. Shareholder's equity is an accounting estimate of the total investment equityholders have made in a firm, and it can be found as a line item on a company's balance sheet. This ratio measures the profit a company produces relative to shareholders' investment in the firm. Because this measure is very widely used, almost all financial websites list ROE values for most publicly traded companies.

When searching for value-oriented investment ideas, my staff and I look for companies with stable or rising ROEs over time. However, as with any financial measure, it's always important to use caution when examining ROE values. For example, if a company has a particularly strong year, then its net income figure can be temporarily inflated, leading to exceptionally strong ROE values. Many tech companies, for example, produced enormous ROEs in 2000 only to see reduced profitability (ROEs) in 2001 and 2002.

The second point to consider is the relationship between ROE and debt. By taking on higher and higher debt loads, companies can substitute debt capital for equity (shareholders) capital. Thus, companies with greater debt loads should be expected to have higher ROEs than companies with clean balance sheets.

Operating Margins
Profit margins measure the amount of income a company generates out of each dollar in sales it generates. Margins tend to increase when a company reduces its expenses, or when it is able to raise its prices at a faster clip than its costs. All of these items are, of course, positives for investors. With this in mind, we prefer to invest in companies with strong -- and preferably rising -- profit margins.

In addition, we prefer to exclude the impact of one-time profits -- profits not related to normal business activities. After all, in most cases these one-time items will not occur again in the future. As such, they don't give us a good sense for a firm's expected future profitability. With this in mind, we almost always focus on a firm's operating margins as opposed to its net profit margins. Operating margins can be calculated by dividing a firm's operating profits by sales.

A good rule of thumb is to look for companies with profit margins of greater than 10%. We also like to look for companies with rising margins over time.

How Do We Look For Value Stocks?

Unfortunately, there's no predetermined path that will allow you to uncover the best value plays. Investing is always a delicate balance of both art and science.

My staff and I frequently scan the market in search of stocks that we believe offer compelling value. We do so by quantitatively screening for companies that score well in the key valuation and profitability metrics discussed above, as well as a host of other important fundamentals. However, don't assume that a list of names that filter through ratio analysis screening is all that is necessary to outperform the broader market averages. Each stock generated by those screens needs to be carefully evaluated, and a close examination of non-numerical data should also be weighed.

For example, in the Clayton Homes example above, Buffett took a hard look at the company's management team before investing. It's always a good idea to conduct a background check on a firm's executives before investing. What credentials or accomplishments do they bring to the job? Do they have prior industry experience, and if so, is their track record commendable? Have they aligned their interests with the rank and file by purchasing shares in the company?

Next, consideration should also be paid to the company's industry, and whether or not the firm has a recognizable edge over its peers. My staff and I always try to identify distinct and defensible competitive advantages before recommending a company. These advantages could take the shape of a powerful brand name, a unique product, or even a patented technology. Remember, companies with sustainable competitive advantages are much more likely to maintain a high level of profitability than those without them.

It is also a good idea to determine whether a company operates in a cyclical market. Some firms -- such as automakers -- typically see their fortunes rise and fall with changes in the economy. The performance of these firms is often tied to broad macro-economic factors; they may look attractive when times are good, but they're also vulnerable to economic slowdowns. In other words, ask yourself whether or not the company's economic moat is wide enough to protect the firm's profitability under difficult conditions. 

Knowledge is power, and it is always important to know as much about a prospective company's operations as possible. This includes a thorough look at its industry, its vendors, its customers, its competitors, etc. Digging through old press releases posted on financial websites like Yahoo Finance is a good starting point. The company's most recent quarterly and annual reports should also be required reading.

Keep in mind, press releases written by a firm's investor relations department will nearly always paint the company's prospects and results in the most favorable light possible. Therefore, it is important to balance that information with objective analysis from other sources. 

Remember, the most valuable articles or bits of information can sometimes run contrary to your opinion on a company. In other words, don't fall prey to ignoring possible warning signs simply because they challenge your thesis on a stock; instead try to poke holes in your own arguments. This will help eliminate costly investing mistakes and allow you to invest with more conviction. 

Successful value investing doesn't necessarily involve uncovering an abundance of potential picks; the key is to be right when you do find a good one. When you've finally made up your mind, invest with confidence and hold for the long term. 

With these points in mind, my staff and I have identified five solid value candidates. This article will continue on April 26...

Paul Tracy will be available to take your questions until Monday, April 25. Please use the form below to submit your questions.