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How I Find The Best Value Shares

By Stephen Bland (TMFPyad)
February 18, 2005

What is the key factor which above all characterises the shares selected for my Value Investor newsletter?

Minimise the downside. The first step to making money is not losing it.

This means that I look first for shares which are likely to suffer less if things go wrong, which have a safety margin of cheap fundamentals. By doing this I am improving the chance of making money by reducing the chance of losing it. Minimising the downside is the primary difference between value and other approaches and comes first in the trawl for potential plays. Only having found candidates which possess this strength do I then begin to consider the upside.

I coined the term 'pyad' to summarise the initial trawl of four common fundamental criteria I use to value shares. And I've been using this method for years, well before the Motley Fool existed in fact.

P - Price/Earnings ratio
I start by looking for a maximum 2/3 of the market P/E. For example, with the current market P/E around 17 I would look at up to 11. I prefer this to be on forecast earnings per share if available in the full knowledge that forecasts are fallible, that is part of the risk you have to take. An ideal situation would be a historical P/E well under my limit with a strong eps rise forecast, thus driving the already low P/E even lower.

Y - Yield
Yield is a nice double edged weapon. It is a value indicator when above the market. I look for at least 50% above it. Thus with the market yield at around 3% at present, I'm looking for above 4.5%. Yield tells you also the level of expected income whilst waiting for the share to do the business, an income which can often be better than cash with a high yielder. Given that a value share can take years to out, it is very useful to derive that income meanwhile.

A - Assets
I am an asset player and this is probably the principal element of the approach. I want to buy the company for less than the net book value of its assets excluding intangibles. So that means a Price/Tangible Book Value ratio under 1. Note that there are assets and then there are assets. The most interesting are those that are likely to achieve at least book value, such as property, cash and realisable investments. This is far more attractive than a load of machinery which is probably worth less than book, though this does not mean that I would ignore an otherwise attractive share if it had very little property etc.

D - Debt
The best level of is no level of debt. Ideal in fact is its exact opposite - loads of cash. Next best is some level of debt but an even greater sum of cash so that the company possesses net cash when the two are set off. Worst is debt or net debt. The reasoning is that debt increases the risk of a business getting into difficulties. In fact when a company goes under, it will be because of excessive debt that it could no longer afford. The greater the debt the greater that risk and vice versa. By having no debt at all plus cash, a company is in an extremely strong financial position.

If a share passes all these four tests, then I call it a pyad share.

Some further explanation of my reasoning:

The P/E ratio is the most widely used comparative measure of the relative value of a share. A share on a ratio of 7 is cheaper than one on a ratio of 30. If the share is already rated on a low P/E, it is less likely to fall than a highly rated share, particularly if earnings expectations fall only slightly short. High P/E shares will often be marked down heavily for a small underperformance in earnings, a much less likely occurrence with low P/E ones. They are lowly rated already so nobody is expecting too much.

Yield is the cash dividend income to be expected for holding the share. I want a bit of compensation while I am waiting for a value share to perform. Maybe it never will, which happens, but then at least I've had something out of it. And if it does perform then a good yield is a nice sweetener. High yield is an ancient and tested indicator of value and is used in my High Yield Portfolio strategy which I also feature in Value Investor. It helps to protect the share from falls because this will only drive the yield even higher, assuming the dividend is secure.

Assets represent the hard facts of what I am getting for my money. Note that book value is not the same as market value, but it is something to go on. Few shares trade below book and those that do may be loss making or there are certain special features that cause this. For example, property companies and investment trusts nearly always trade below book. But a trading company share with a P/TBV under 1 tends to put a floor under the share price and as a bonus makes the share attractive to a bidder.

Debt in my view is a negative aspect of a value share. The more debt the company has, the more risk is present in buying the shares because the loan holders have to be paid their interest come what may plus their capital at some stage. Compare this with cash and you can see that a burden has been lifted from the company. Not a lot of harm can come to it in such a case. And as an added bonus a company with a lot of net cash is extremely attractive to a bidder.

Having shown the four features, they are not written in stone. I will be flexible in good cases, though not on P/TBV<1. Buying below book is the major factor of the pyad approach. But on yield, for example, I may not insist on a yield of 50% over the market if the other factors match up.

There are a few other security features to which I am attached. I prefer a big cap to a small cap pyad share, assuming I have the luxury of choice. This is because I have found by hard experience that smaller caps are less reliable for several reasons. A larger cap value play can go wrong of course, but it is less likely.

The above all have the aim of minimising the downside. The first and most important step by far in value share selection. Shares passing these filters will be far less likely to fall than non value shares. I must point out though that pure pyad plays are rare. Consequently many of the shares selected for Value Investor will not have all the features but they will possess as many as I can find.

Next week it's the turn of the upside. We've found our shares with the risk as low as possible. Now we want to make some serious money out of them. But why should they go up when everyone else has been getting rid of them?

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