5 Ways to Help you Identify Great Investments

A value stock by definition has to be cheap, but for value to exist, there has to be some certain criteria to differentiate it from a value trap.

Here are 5 basic yet highly effective ways of identifying a value stock that is turning profitable or improving operations. The following methods are especially helpful for small to micro cap companies.

1.       Cash flow positive or slow cash burn

One of the key methods to identifying profitable companies. Cash is king and any company that is generating positive cash flow is a keeper to start with. If a company had years of negative cash flow and is now starting to show signs of positive cash flow, a big turnaround could be in process which will lead to an increase in earnings, followed by the stock price.

2.       Debt reduction

The crippling factor of a company during difficult times. When the economy is booming, debt can work as leverage to produce bigger returns, but during a recession or a cyclical downturn, debt burdens the company further as it has to pay interest as well as keep within the debt covenant. Look for companies that have been consistently reducing debt. If there is zero deb to begin with, consider adding it to your watchlist.

3.       Share count reduction

If the number of shares outstanding is reduced, shareholders are entitled to a bigger piece of the company pie. For example, if the market cap of the company is $10m with 10m shares outstanding, and the share count is reduced to 5m shares, the $10m is now being divided among 5m shares. As you can see, you may still hold the same number of shares, but you are entitled to twice as much.

Look for companies that reduce their share count when there stock prices are at low levels. Be wary of companies that repurchase stock when the price is near the top or just because it has cash lying around.

4.       Insider buying

Insider buying is always a great sign. It shows that insiders are confident in the future prospects of the business and signals that the price at which they bought is a cheap price. Michael Dell is a classic example. He has purchased more than $150m in the open market of his company Dell DELL. Such purchases by several insiders suggests that the company is bullish on the outlook of the company and ready to eat their own cooking.

5.       Increasing NNWC

An important aspect to a company are its tangible assets. If a company has tangible assets, there is a hard value assigned to those assets compared to intangible assets which can be written down without a second thought.

NNWC stands for net net working capital and only considers the assets to consist of cash, receivables and inventories minus total liabilities. It is a very conservative measure of liquidation value and to calculate an approximation of what a company would fetch in a fire sale.

If the NNWC of a company is positive, the company has more current and liquid assets compared to total liabilities. An increase in NNWC over the quarters demonstrates that the company is increasing valuable assets or decreasing liabilities. Both a positive signs.
Even though these are just 5 basic conditions, many companies do not pass all of them. But keep your eye out for the ones that do pass the test and prepare to back up the truck when the price is right.
Jae Jun runs Old School Value, a value investing service providing stock valuation spreadsheets, stock analysis and value stock screens for the DIY investor. He writes a weekly Tuesday column for Benzinga.