What's a value investor to do?

At a time when almost every stock is on sale, it's harder to sort out the real deals from the junk.

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By Joe Light, Money Magazine staff reporter

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(Money Magazine) -- Value investing in a deep recession is a bit like trying to bargain hunt at a dollar store. At first blush you're overwhelmed by the prices on just about everything. A value investor is, after all, drawn to beaten-down stocks trading at low prices relative to earnings.

But in this market, "you could start randomly typing in ticker symbols and find shares that are cheap," says Bill Nygren, manager of the value-oriented Oakmark Fund. That doesn't make them all good deals.

When shares of nearly every company in all sectors of the market are down sharply, as is the case today, you need to be more discerning about what makes a stock cheap. And to create an extra margin of safety, says Thomas Shrager of the investment firm Tweedy Browne, you should stick with "companies where the probability of them going under is very small."

Here's how to go about it:

Comparison-shop on P/Es. At first glance, a stock might look cheap at a price/earnings ratio of, say, 11, which is below the market's average of 13. But it's not that simple. Just as shoppers pay different prices for Italian wingtips and flip-flops, the market sets different valuations for different types of firms.

The only way to tell if a stock is really on sale is to compare its P/E with those of companies in the same industry. You can find sector ratios at standardandpoors.com. Click on Indices and go to the S&P 500 section.

Understand the business. When you screen for companies with extremely low P/Es, you'll run into some risky shares. After all, if a stock is priced significantly below its peers, either something is wrong with the firm or investors think there is. Take the troubled insurer AIG (AIG, Fortune 500). It trades at a P/E of just 7, based on projected future earnings. But how confident are you that AIG will post profits this year?

This is why it's important to invest only in firms whose business models you fully understand, says Wally Weitz, president of the Weitz Funds. Frankly, that writes off much of the financial sector, since no one seems to know all the counterparty risks banks and brokers are exposed to.

By contrast, you might consider a stock like Nike (NKE, Fortune 500) (see the chart above). It's no secret how this firm makes money - shoes and apparel. And while it's threatened by the recession, Nike has a solid balance sheet, a powerful brand, and is making inroads into the lucrative Chinese market.

Avoid firms with big debts. The father of value investing, Benjamin Graham, argued that financial troubles are often "heralded by the presence of bank loans." So he favored companies with low debt.

Graham, in particular, preferred companies in which working capital - defined as current (or liquid) assets minus current (or short-term) liabilities - exceeded long-term liabilities. In theory, those firms, which include companies like Nike and the oil driller Ensco International (ESV), have enough assets on their balance sheets to meet all their obligations.

At least make sure the company generates enough cash to pay off debts maturing in the next few years. Why? It used to be that firms could simply refinance when debts came due. But in this credit crunch, that's no longer a given, says Bill Fries of the Thornburg Value Fund. You can look up cash-flow figures here. But you'll have to look in the footnotes of corporate annual reports to find out how much debt is coming due soon.

If you don't want to do the leg-work, there are plenty of portfolios that follow value guidelines. Several can be found in the Money 70, our recommended list of funds, including T. Rowe Price Equity Income and Weitz Hickory.

All of these portfolios charge lower-than-average fund fees. And that's important. After all, you're bargain hunting.  To top of page

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