The Top 5 Ways To Find Bargain Stocks In Any Market

Stockopedia
updated | Author's Website

When it comes to buying stocks, few investors would dispute that finding a bargain is a seductive prospect. But while most investors are looking for an attractive price, some bargain – or deep value – investors are prepared to great lengths to find one. Warren Buffett calls it the cigar-butt approach to investing: 

A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the quot;bargain purchasequot; will make that puff all profit”. 

Bargain investing is all about having a very conservative measure of intrinsic value, essentially liquidation value, and a significant margin of safety, in order to trying to buy a pound for, say, 50p. In bull markets, true bargain investing can be an arduous (if not impossible task), but in depressed and volatile market conditions the basket of potential stock candidates tends to swell. Regardless of the conditions, some of the world’s most legendary investors like Benjamin Graham and Walter Schloss have made a mint out of this investment approach. 

So how do you go about finding these kinds of deep value or bargain stocks? 

1. Bargain Investing 101 – Low Price-to-Book Investing

Perhaps the most common way to measure liquidation value is by using the price-to-book ratio. This involves comparing the current market cap of the company with the book value of the equity in its balance sheet – this is the difference between the book value of assets (cash, accounts receivable, inventory, fixed assets) and the book value of liabilities (loans, accounts payable, mortgages, etc). Countless academic studies have shown that low price-to-book stocks tends to outperform over time

Price-to-book can be calculated on a tangible and intangible basis. True bargain investors would tend to be dismissive of any kind of intangible assets, usually calculating price-to-book on a tangible assets only basis, given the inherent difficulties in valuing intangibles and the scope for flexibility in accounting for them. That’s fine for manufacturing companies but, of course, this makes it unlikely that they would invest in most service businesses (as the value in, say, a consultancy company, lies with the knowledge of its workforce – which is an intangible which isn’t even on the balance sheet). 

However, even after adjusting for intangible assets, hardened bargain investors may be sceptical that price-to-book is a sufficiently robust measure of value. It may not give enough quot;margin of safetyquot; to their investment in the event of a severe downturn if fixed assets may have been overvalued. As a result, a number of other (even more hardcore!) approaches can be used… 

2. NCAV Investing the Ben Graham Way 

Any assessment of bargain investing will inevitably touch on the teachings of Benjamin Graham who, amongst many things, took price-to-book and gave it a twist. For the father of value investing and tutor of Warren Buffett, NCAV investing – or the scrutiny of a company’s net current asset value – was a key factor in Graham’s style of cigar-butt investing. In essence, an NCAV strategy involves buying stocks that, if they were to collapse tomorrow, should still produce a positive return because of the underlying asset backing. 

While Graham acknowledged the importance of price-to-book as a measure, he demanded greater detail. He proposed taking current assets (such as cash, stock and debtors) on the basis that these items could easily liquidated in the event of total failure, and then subtracting the total liabilities to arrive at the NCAV. Any stock trading at a market price lower than NCAV was a potential prospect, although Graham also looked for a margin of safety of about 33% below that level. 

Graham applied several other stipulations to support the NCAV model, among them the requirement to diversify the strategy to at least 30 stocks in order to defend against the risk of individual failures. However, his overarching belief was that a company with a market valuation that was less than its liquidation value indicated that the market had mispriced it or that the company should be sold or liquidated. In bull markets, NCAV stocks can be few and far between but in depressed conditions there is far more to look at – indeed there are currently 50 UK-listed stocks appearing on the Stockopedia PRO Benjamin Graham NCAV screen. 

3. A Margin of Safety with Net Nets

For investors that like the idea of NCAV, it is worth nothing that Graham pushed the formula a stage further with something called Net Net Working Capital. Essentially, this again looks for the liquidation value of a stock but whereas NCAV treats debtors and inventory as items that one can assume a 100% return from, NNWC builds in a margin of safety: 

NNWC = cash and short-term investments + (0.75 * accounts receivable) + (0.5 * inventory) – total liabilities. 

What Graham is saying here is that in a liquidation situation, cash due from debtors and the value of inventory may not be fully realised in a firesale – some debts may not be recovered and some stock may be discounted, so he made allowances. 

4. Cash is King with Negative Enterprise

An alternative way of dealing with the “known unknown” of the true value of tangible assets in a liquidation situation is to deal simply with the cash in a business. By applying a Negative Enterprise Value screen, investors can look for companies whose cash is worth more than the total value of their shares and long-term debt. 

The approach involves identifying the small basket of shares in the market that are trading at a negative enterprise value – in other words, companies with a market cap that is lower than their net cash balance. Why would you want to do this? Proponents argue that stocks in this position offer a potential arbitrage opportunity, whereby a buyer of the company could snap up the entire stock and use the cash to pay off the debt and still pocket a profit. 

For the individual investor, this means buying into the cash at a discount and receiving a claim to the rest of the company for free. The argument goes that in an efficient market something would eventually have to give and the company would either be acquired, turned around or pay out a dividend. 

Unsurprisingly, a Negative Enterprise Value approach is pitted with risks. Judging a company’s current cash position, as opposed to its last reported cash position, is fraught with difficulty, and there is also no guarantee that the company management will act in the best interest of shareholders. Nevertheless, there is evidence, particularly in the US, that the strategy can work well, although there is no known back-testing of the method in the UK. 

5. New Opportunities with New Lows

A final thought for bargain investors blends the all-important book value with stocks that have fallen to new lows in terms of market price. You can track the list of New Lows as part of the Stockopedia PRO screener. This approach was taken by Walter Schloss, another investor that studied under Graham and refined his theories into his own strategy. 

During his time as a fund manager, Schloss was known for looking intensively at the numbers (rather than at computers or meeting management) with an approach that, he explains, also looks for:

“Cheap stocks based on a small premium over book value, usually a depressed market price, a record that goes back at least 20 years…and one that doesn’t have much debt”.

Over the 45 years from 1956 to 2000, his fund earned a CAGR of 15.7%, compared to the market’s return of 11.2% annually over the same period. 

Schloss preferred to invest in sectors he understood, particularly old industries like manufacturing, although he successfully shorted Yahoo and Amazon before the markets collapsed in 2000. Like Graham, Schloss believed in significant diversification although his willingness to run up to 100 stocks would have many investors reeling. 

But is bargain investing worth it? 

This kind of investing is not an approach for the faint-hearted. Warren Buffett argued against it as a strategy in his 1989 Chairman’s Letter to Shareholders, noting that: 

“The original “bargain” price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces – never is there just one cockroach in the kitchen. Second, any initial advantage you secure will be quickly eroded by the low return that the business earns.” 


Certainly, by definition, bargain investors do tend to get their hands dirty with some of the most unloved stocks in the market and that leaves any bargain strategy open to significant risk.

While scrutinising the relationship between market price and underlying asset value (however you choose to do it) can prise open a basket of candidates that could offer substantial returns, investors should always back up their screening with detailed scrutiny as well.

Some useful quantitative tools that can help assess the financial health and viability of bargain stocks are the Piotroski quot;Financial Healthquot; F-Score, the Altman quot;Bankruptcyquot; Z-Score and the Beneish quot;Earnings Manipulationquot; F-Score. We now print the three indicators on all of our Stockopedia PRO Stock Reports!

You may also like: