-- Philip L. Carret

As the late stages of this great bull market have been playing out, we’ve finally seen a shift in what investors are looking for. Suddenly, just getting caught up with and effortlessly riding the overall upward wave--a strategy which has become known as momentum investing--is no longer enough. Momentum issues now are in the press as much for their spectacular recent losses as for their previous but fleeting gains.

Value investing is a strategy which focuses on the fundamental strengths of an individual stock; though in some cases, you might take advantage of the relative strengths of an entire industry, or sector, of the market. First, you want to identify specific companies who, on their own merits or due to their industry, appear to have a bright future. A corollary here is to look for cyclical industries that are currently undervalued, relative to the market as a whole.

Value can be measured in three key ways. First, it is measured by a stock’s book value. This is the figure that a share of a company’s common stock is worth if you were to liquidate the company, pay the bills, and split up the remainder among the shareholders. The average book value of the Standard and Poor’s 500 average is currently more than 6:1. This means that shares are currently priced at an average of more than six times what a company is worth if it were sold; an historically--and disturbingly--high level. So, you first want to look for stocks that arereasonably priced by this measure.

Next, you need to look at a stock’s price-earnings ratio. This is the multiple a stock trades at compared to its annual earnings. If a company earned $1.00 per share last year and its stock is currently selling for $10.00, its price earnings ratio is 10:1 or, simply, 10. Here again, if welook at the S&P 500 the average P.E. ratio there is currently over 27, based on this year’s expected earnings. While this is not its highest point in history, it is close.

You should also look at a stock P.E. ratio in relation to its own growth as a company, as well as future growth projections. A company selling at a P.E. of 10--less than the market as a whole--might not be attractive if it has only exhibited annual growth in earnings of just five percent. On the other hand, a stock with a higher current P.E. multiple of 20 might be considered quite attractive, if it has shown explosive earnings growth of 50 percent per year which is expected to continue.

Not only do you want to look at a stock’s P.E. ratio relative to the market generally, but also as compared to its industry. All things being equal, for instance, a heavy equipment maker selling at a P.E. of 10 will generally be attractive if the average P.E. among other stocks in its industry is 15.

The third fundamental factor to consider is a stock’s dividend. Believe it or not, some companies really still pay dividends, even in 1998! If you can find stocks meeting the preceding criteria which also pay dividends, you have an issue that will usually allow you to sleep at night, even if the market goes down.

Key things to look for are past--or expected future--increases in the particular stock’s dividend payout. Additionally, it’s important to make sure that--with the exception of limited partnership units, real estate investment trusts and the like, part of whose payments areconsidered a return of principal for tax reasons--a company’s dividend is comfortably met by its current and projected future earnings. Wall Street traders have little sympathy for a company that is forced to cut its dividend without a darn good reason (Ryland Group, for example, was an exception to this.)

SOME MISCELLANEOUS TIPS

Entire books have been written about the stock market. Obviously, I can’t duplicate every bit of good information from them in this article; however, especially for those of you investing for growth, something as simple as the information on value investing above can serve you quite nicely just on its own.

Following are several other do’s and don’ts and additional ideas that may be of some help and interest:

--Look for low market caps. This term is short for a stock’s market capitalization, or the total value of its outstanding shares. Companies with relatively low numbers of shares outstanding have more room to grow than those which don’t; while this rule doesn’t hold for a company whose individual fortunes are not otherwise good, it’s something to look at. I’m one of those of the opinion that--as the current correction unfolds, and as major multinationals’ earnings continue to disappoint--investors will look anew for the best values among small caps.

One factor here to be careful of is dilution. While a company might have a relatively small number of outstanding shares now, it might have expansion plans or needs for cash that will cause it to issue more shares. If this happens without a commensurate increase in the value of the company’s assets or an increase in its business, this will serve to dilute the value of existing shares. Such a move can obviously be in the best long-term interests of a company by adding value to the existing shares--as Claude Resources has recently done, and as Tengasco is in the process of doing.

--When looking at company earnings, also look at revenue growth. I’ve seen many examples of companies whose earnings growth has been unexciting, but whose business volumes and revenues are exploding. Often, the explanation is that a company’s growth costs, or possibly recent acquisitions, still constitute expenses; once these are digested, much more of its growing revenues will show up on the bottom line. If there’s a reasonable explanation of revenue growth soon translating to earnings, jump on a good issue before the crowd does.

--You must diversify. Investors have learned the hard way in the past that no matter how good an individual stock looks, you shouldn’t put all your eggs in one basket. Diversification, as well as proper and timely allocation among industry groups, can be used as a defensive measure during times of general overvaluation of stocks as well. Even long-term investors in growth stocks, for example, might consider shifting some money to more conservative, income-oriented issues at such a time, to lessen the overall risk in their portfolio.

--Continually re-evaluate your stocks. As the weeks and months go by after a stock purchase, continually ask yourself the question, "Would I buy this stock today?" If the answer is yes, hang on to it--or buy more. If the answer is no, sell it regardless of the price.

The latter is where many investors regularly get into trouble. An extremely common mistake is to become "married" to a stock that has turned into a loser. Seemingly a million times, I’ve heard people say, "I’ll sell when it gets back to what I paid," when I tell them they should get rid of a loser in their portfolio. Sometimes, it never happens! If a stock you own is down--and there is no reasonable chance for a recovery any time soon--sell.

--Follow the momentum investors. Sometimes stocks with legitimate value are seized upon by momentum players. The destruction often caused by these speculators can open up some interesting opportunities for value investors. Those of you who follow the markets have often seen good companies get punished severely for publishing earnings reports that don’t meet analyst’s expectations--even though they might be good! Quite often, solid companies will have their shares driven down to levels where the company is quite attractive; we’ve jumped on several of these in the past.

Occasionally, good value stocks get caught up with an overall market decline--such is the case lately, with the stock market retreat broadening dramatically. I like an analogy used by mutual fund manager Bill Berger some time ago, when he commented in regards to value investing that, "The trick in a declining market is to be invested in tennis balls rather than eggs."

Part 2

The concepts I discussed last month--and those which follow--deal primarily with identifying long-term value in stocks. In recent years, whether we like it or not, it has become a bit more important to also be a trader at times, and to--when appropriate--carefully follow the short-term gyrations caused by momentum investors.

But just as in the story of the tortoise and the hare, slow, steady and methodical usually wins out in the end. In addition to those pointers I gave in the last issue, keep the following in mind as well:

--Have Patience. Patience is the rarest commodity on Wall Street and therefore, the mosthighly rewarded. Most investors sell too soon--this is especially true when a stock is going down. Now--in cases of momentum issues, or with stocks you take a "flyer" on that are primarily speculative in nature--downturns can feed on themselves, and share prices can stay in the basement for quite a while into a new spurt of positive news bolsters them again. With the former (momentum) issues, you might need to employ a stop-loss; with the latter, of course, you shouldn’t have a high percentage invested in speculative issues to begin with. And--when you do--it’s usually best to stick with them for as long as their story/concept appears viable.

With legitimate value issues, though, as long as you "bought them right," you need to have the patience to hang in there. Keep Mr. Carret’s quote above in mind. Also, as I’ve recommended before, always ask yourself the question, "Would I buy this stock today?" in regard to your holdings. Yes--issues such as United Heritage have been a relative disappointment so far. In this case, however, we know the value of the company--and we also know the reasons why its share price has not yet sufficiently reflected it. The company’s 100 million plus barrels of recoverable oil have gone no place. Management--though unfortunately too slow in marketing itself to investors until recently--is otherwise solid, competent, and very honest. The company represented a good long-term value at double its current share price; now, it’s a steal. The worst thing to do with such an issue is to lose patience.

When you understand your investments, your knowledge will be the armor you need against the overwhelming urge to follow the crowd. Once you embark on the adventure of owning a stock, stick with it until it has proven your assumptions wrong.

--Know what you own. Having patience is that much easier when you have done sufficient research on a company to begin with, and keep up with news. Most public companies these days have Internet web sites, on which they post news releases, earnings statements, and the like. In addition, many will put you on a fax or mailing list to send you these same updates as they come out.

--Buy slowly and deliberately. As your Editor, I currently have a grand total of about 130 stocks I follow on virtually a daily basis. I have several stacks here in my office of due diligence packages on most of them, in addition to a plethora of other reports and such I’ve obtained from the companies’ own web sites and various reporting and news services.

This month, I’ve recommended only one.

Perhaps the hardest thing I go through here is not having to deal with those few stocks on the back page that have been disappointments. Instead, it is being so deliberate in getting comfortable with a company that I often don’t recommend one that does indeed take off. Even such care won’t give us a 100% batting average--but in the long run, we’ll do better than most everyone else, as our longer-term performance attests.

True value stocks aren’t here today and gone tomorrow as a rule anyhow. So--to the extent that you do this kind of research on your own--take your time. You can stay glued to CNBC and the Internet 24 hours a day, and still only be able to acquire information on a tiny fraction of opportunities that are out there. So don’t chase "hot" issues. Take your time. Do your homework.

--Know when to "average down." At times, the most solid value issues disappoint for various reasons. A good company will have a bad quarter once in a while. Sometimes a newresearch project doesn't work out and needs to be written off. Maybe anticipated revenues don’t materialize as quickly as hoped, but will instead be realized in the not too distant future. These things will temporarily hurt earnings. Also, general weakness or bad news in a market sector often takes the good companies down a few pegs along with the shaky ones.

Traders will dump the stock and move on; but this opens up an opportunity for the value investor. The latter--especially if already invested in the stock themselves--will go to the trouble to look beyond just the disappointing news to see what caused it. If it's a one time event, that means a bargain is at hand.

Provided the same justification remains that first persuaded you to buy the stock, use periods of weakness to buy more, as long as that does not result in your being overly invested in one or two issues. In this way, when a rebound does come about, your overall per share cost for the stock you own will be less than it was initially, making your break-even point often well below your initial purchase price.

Similarly, don’t be afraid to "average up" if a stock’s fundamentals are actually improving more than the share price. Again--Would I buy this stock today?

--Know yourself. As you think about putting together a stock portfolio, think about what you want from that group of investments financially--and the realistic level of your own expected involvement. If you’re retired and fairly conservative by nature (which most retired folks are) don’t construct a "value" portfolio made up primarily of low-priced stocks, half of which don’t have earnings (even if they’re recommended here.)

Think about how your investments will affect you emotionally. If you are highly conservative, stick more with low-PE stocks, at least some of which pay decent, reliable dividends.

Invest according to your own strengths and knowledge as well. While you should always keep the principle of diversification in mind, particular experience in a certain industry might dictate that your portfolio be more heavily invested in good value plays in that sector than in others (providing the particular industry’s fundamentals are positive.)

--Accept losses. After buying an issue with good value, good fundamentals, and for all the other right reasons, it still does occasionally happen that the story turns sour. Learn to distinguish between temporary bad news or explainable delays in the company achieving parts ofits business plan on the one hand, and a structural breakdown on the other. If the latter occurs, take your lumps and get out. If you’re properly diversified to begin with, no one stock will cripple your portfolio, at least for very long.

Finding good stocks is like hunting for gold. There is high anticipation, many wrong turns made, much that glitters that isn't what you're looking for, and--once in a while--a true, huge nugget is unearthed. Following the basics of value investing won’t guarantee perfection; it will, however, keep disappointments--and sleepless nights--to a minimum.