5 Keys To Spotting Value Stocks

In his book Investment Fables, Aswath Damodaran looks at what does and does not work in the stock market. He examines various theories of stock selection including the value, growth and momentum approaches.

Value investors know that buying stocks that trade below book value outperforms the market, but may be surprised by Damodaran's keys to maximizing the approach. His research showed that investors should focus on stocks with five features:

• trading below book value
• not overly leveraged
• earning a return on equity of eight percent
• not overly volatile
• trading for at least $3 per share.

Related: 6 Books Every Value Investor Should Read This Summer

To act on his ideas, set a screen that searches for stocks that meet his base criteria, and discard any that trade below $3 or are very volatile. One such screen is:

• Price to Book Value Ratio of 80 percent or Less
• Debt to Capital Ratio less than 70 percent
• Return on Equity of More than eight percent

After an extended market advance the past few years, it should come as no surprise that very few US stocks pass the test right now. Markets trading at all-time highs tend to offer a very limited opportunity set for value investors.

Just 12 companies make the grade right now. The list is heavily skewed towards financials, with banks and insurance companies dominating the list. Four value opportunities are profiled below.

The largest company in the list of potentially market-beating stocks is none other than American International Group AIG. After serving as the poster child of too big to fail bailout institutions, the company has started to get its act together.

The company provides a wide array of financial services including property and casualty insurance, life insurance, retirement planning and mortgage insurance. The shares currently trade at 75 percent of book value and AIG earns a return on equity of 9.04 percent. After being recapitalized, the debt to equity ratio is currently 0.38 so it passes the leverage threshold as well.

The company has made great strides over the last few years, but there is still a long way to go. If it continues to succeed with its turnaround, the stock could be a lot higher a few years from now.

Renewable Energy Group REGI is in the biofuel and renewable chemical business. It converts natural fats, oils and greases into advanced biofuels and in turn, diverse feed stocks into renewable chemicals. The company trades right at 80 percent of book value and has a return on equity of 30 percent.

The debt to equity ratio is just 0.33 after the recent convertible notes offering. Right now Renewable Energy is the only non-financial stock on the list of potentially market beating cheap stocks.

Atlantic American AAME is in the insurance business and sells life and health as well as property and casualty insurance. The stock sells at 76 percent of book value and the company earns a return on equity of 10.9 percent.

The debt to equity ratio is just 0.40, so the stock passes the leverage threshold as well. The company has been taking advantage of the low valuation and recently authorized a new 750,000 share buyback.

CNO Insurance CNO is yet another insurance company that makes the grade. It sells life and health insurance through agents and direct marketing through their three subsidiaries: Bankers Life, Colonial Penn and Conseco Insurance Group.

The stock sells at just 75 percent of book value and it earns a return on equity of 9.65 percent. The debt to capital ratio is right at the upper limit of 70 so it is one of the more leveraged stocks that passes the filters.

The approach outlined by Professor Damodaran has been proven to be a very effective method of picking stocks for long term returns. As with most other value oriented approaches to the market, right now there simply are not many opportunities.