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Value Investing

Find quality companies on the cheap

If you're a value investor, you're looking for bargains. The key is finding quality stocks for cheaper prices. A "cheaper" stock is not the same as a low share price-for value investors, "cheap" means undervalued.

With this strategy, value investors try to find companies that the market has overlooked and that are selling at a discount to their book value. Smart? Yes. Easy? No. In fact, it's what most investors would like to do and only some manage to achieve. So how do you make a value strategy work?

Consider making a plan

Some value investors are strictly buy-and-hold. They expect to wait a long time for the stock price of an underpriced company to reach its potential. Underpriced is another way to say undervalued.

Other investors set a target price when they buy and sell off part - maybe a third - of their holding each time the price increases by a certain percent - maybe 15 percent or 20 percent. This approach lets them protect part of their gain along the way.

Either strategy may work. But keep in mind, you can't switch randomly between the two. That's not a strategy. Also, there's no guarantee of success, no matter which strategy you choose.

Shop around

You may be able to identify undervalued stocks using metrics like price-to-earnings (P/E) ratio, or price-to-book value (P/BV) ratio. Value stocks come in at the low end of the current market average P/E and P/BV. Their prices tend to be flat, and they might not be getting much attention in the press.

Value investing works best when investors understand why a company is promising, based on things like its assets, revenues, earnings, profit margin, and debt levels. Look carefully, though - with a closer look, you may also find the red flags that explain why a stock's price is lower than you'd expect it to be.

So why isn't everybody a value investor? Doing it well is hard work and it involves making judgment calls. If you get it wrong, you lose. Here's why: The same details that put a stock on a value investor's radar can be signs of a disaster waiting to happen. Take a low P/E ratio, for example. It could be evidence of enormous, unrealized potential and an eventual resulting price increase. Or, it may be an ominous sign that the end is near.