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Value Stock-Picking, Week 2: How to Pick Bargain Stocks

Looking for good deals in the market? Here's how to find them.

Editor's note: The Value Stock-Picking Training Program is a series of four weekly assignments. (To start with Week 1, click here.) Each assignment is based on one of James Altucher's strategies in his book, Trade Like Warren Buffett. To get a copy of the book, click here.

This assignment was written by Stockpickr member Ira Krakow.

Don't you just love a bargain when you find one at a flea market or a yard sale? Many times, bargains can be found in the stock market as well. This week, you will learn how to go shopping for the best bargain stocks.


Trade Like Warren Buffett


James Altucher cites Warren Buffett's two rules for finding bargains:

Rule #1. Don't lose money. Rule #2. Don't forget Rule #1.

Altucher quotes another Buffettism: "The secret to success is figuring out who to be the batboy for." Buffett was the batboy, so to speak, for Benjamin Graham, the "father" of

value investing. Graham's favorite strategy was to find companies that were trading for cash (see

liquidity) and then hold on to them until they traded for more than cash. But how do you do that? Buy stocks when they're "on sale."

Price-to-Book Ratio

Value investors like Buffett are always bargain-hunting. Here's one approach to spotting a bargain stock candidate. Look for a company whose stock price is close to or even less than its

book value per

share. Look for the stock's

price-to-book value ratio, a measure of what the company is worth per share if all of its assets were liquidated.

If a company's stock price is 1.5 times its book value per share or less, it's certainly worth looking into further as a potential bargain stock. Even more of a bargain: if the stock price is

less than

its book value. That means that if the company's

assets were sold, the proceeds of the sale would be worth more than the value of the outstanding stock.

Here are two Stockpickr portfolios to start with in your bargain search:

  • Value Line Stocks Trading Cheap Vs. Their Book Value: This is a portfolio of stocks that Value Line believes can increase in price, but whose book value per share makes them a bargain.
  • Five Book Value Bargains: Compiled by Forbes, this is a list of stocks can be called cheap.

Don't use the price/book ratio as a hard and fast rule for bargain-hunting, however. A stock can stay cheap for a long time, with its value unrealized. If the company isn't

growing, its stock is not really a bargain -- it's "dead money."

Sometimes a company with a low price/book ratio can be a serious losing proposition. Take

Sonus Pharmaceuticals


. To see the price/book ratio for Sonus, go to the SNUS quote page on Yahoo! Finance. On the left-hand side, click "Key Statistics" and scroll down to the "Valuation Measures" section. In that section you will see the "Price/Book (mrq)" number, which is 0.65 for the most recent quarter.

The Sonus price/book ratio number means that the market is valuing the company at roughly two-thirds of its asset value. Sonus trades at even less than its cash in the bank and has zero

debt. The stock looks like a screaming bargain, right?

Hold on, don't buy so fast. Sonus is a

venture capital-financed biotech company that has bet its future on one drug -- Tocosol -- which, if approved by the FDA, would have been a blockbuster drug in fighting breast, ovarian and other forms of cancer. Unfortunately,

the results of the FDA study were disastrous, causing its stock price to plunge 84% in one day.

What gives? The Street has a name for companies like Sonus that look like bargains on paper but are in fact dangerous to your financial health. They're called "value traps." Simply put, the market doesn't believe that Sonus is viable as an ongoing business. Instead, it thinks that Sonus cannot recover from this catastrophe. This situation happens a lot in biotech,

which is an investment jungle. (For an excellent compass to guide you through the biotech jungle, read

Adam Feuerstein's columns on


Price-to-Earnings Ratio and Risk


Trade Like Warren Buffett

, Altucher cites the Bible of value investing,

Security Analysis

by Graham and Dodd, on investment bargains:

"Common stock of companies which: (a) are selling below liquid asset values; (b) are apparently in no danger of dissipating these assets; and (c) have formerly shown a large earning power on the market price may be said to truly constitute a class of investment bargains."

The price-to-earnings ratio (

P/E) is another metric frequently used to look for bargain stocks. When you compare a company, say a bank like


(C) - Get Report

, with its competitors, say

Bank of America

(BAC) - Get Report


Wells Fargo

(WFC) - Get Report

, or

Washington Mutual

(WM) - Get Report

, you might think that the stock with the lowest P/E ratio is the best bargain. Often, this is the case. But sometimes, as in the recent

subprime mess, you can be tripped up by the earnings. Even though a company reports great earnings one quarter, that doesn't guarantee great earnings for future quarters (see

"Five Missteps to Avoid in Earnings Season"). For example, Citigroup

wrote off more than $3.4 billion in the most recent quarter.

Altucher lists three ways that earnings can be threatened, and how seriously Buffett considers these threats. This list of threats includes market risk, litigation risk and a setback in the business.

Market risk.

Will Buffett sell his holdings because the market is taking a beating, because of a major external event like the attacks on Sept. 11, 2001? Generally, the answer is "no." If the company's

fundamentals are solid, he tends to wait until the market realizes the stock's

intrinsic value.

Litigation risk.

Cigarette stocks, such as


(MO) - Get Report


Reynolds American RAI


TheStreet Recommends

, or

British American Tobacco BTI

(BTI) - Get Report

, are periodically affected by class-action lawsuits from cigarette smokers. Most of the time, the suits are settled without materially affecting the stock price. Again, if the fundamentals are good, Buffett would tend to continue to hold these stocks because in the long run, these stocks should shake off such temporary bad news.

Business setback.

When the mad cow disease scare hit, this turned out to be a temporary setback for


(MCD) - Get Report

. However, McDonald's stock price has roared back since then. A value investor needs to overcome such fears if the initial analysis of the stock's merits is still valid.

Of course, if, as in the case of Sonus, if you decide that the news is indeed bad for the stock, you would need to sell. The point is that you need to monitor developments that might affect your

portfolio and take appropriate action, if necessary.

Now let's get to this week's assignment.

Your Week 2 Assignment

Jim Cramer often writes that

diversification is

"the only investment concept that truly works for everyone." Let's suppose that you have determined that a stock in the semiconductor sector belongs in your portfolio. Which one would you buy? That's the goal of this week's assignment: Pick the best bargain stock in the semiconductor sector.

Although this assignment focuses on semiconductors, you can use this methodology to zero in on the best bargain in almost any sector.

To help you get started, I put together a

Stockpickr portfolio of semiconductor stocks featuring stocks that are part of the

Semiconductor Holders ETF

(SMH) - Get Report

, an

exchange-traded fund managed by Merrill Lynch.


Step 1.


Stockpickr, create a portfolio called "Semiconductor Bargain Stock Research:

Your Stockpickr Username." (To create a portfolio on Stockpickr, you'll need to first log in. If you're currently not a Stockpickr member, you can register at Make sure to turn the "Portfolio Tracking" feature on, so you can monitor stock prices over time.

Step 2.



(INTC) - Get Report

, and

Advanced Micro Devices

(AMD) - Get Report

to your Stockpickr portfolio. Why start with Intel and AMD? Between them, Intel and AMD represent almost 100% of the PC server processor market. (According to a recent


article, as of September 2007, Intel owned approximately 87% of this market and AMD owned 13%.)

Step 3.

Do some

fundamental work to see which stock is more of a bargain. Check both companies'

price/book ratio and

forward price/earnings ratio at Yahoo Finance. (To find these ratios for a stock, enter the stock's ticker symbol. Then on the left-hand side of the main quote page, click "Key Statistics" and scroll down to the "Valuation Measures" section, where you'll see the "Price/Book" and "Forward P/E.")

Also, check out the

dividend payout ratio and the stock's

PEG numbers, as you did in the

week 1 assignment. Log your results in the "Reason for Picking" box for the respective stocks.

Based on your research, would you buy Intel or AMD as a relative bargain stock? Or perhaps as a dividend play?

Step 4.

Read the news about each company by searching for articles and videos at

and other sources.

Based on the news, are there any recent positive or negative developments that would make you choose one company over the other?

Step 5.

Add four other stocks from the Stockpickr

portfolio of semiconductor stocks to your portfolio, and do the same research (see steps 3 and 4), as you did for Intel and AMD.

Are any of those four names a better buy?

You might find that companies that make equipment for semiconductor manufacturers, such as


(KLAC) - Get Report




might be better plays than the semiconductor manufacturers themselves.

Step 6.

Rank the six stocks in your portfolio and make sure to explain the reasons for your rankings.

Step 7.

Follow these stocks for the next three weeks to give the market enough time to validate your picks. Then rank them at the end of the period. Was your analysis correct, or did a stock break out of the pack or perhaps lag?

As you build a diversified portfolio, including stocks in a number of sectors, you can use this step-by-step process to help you pick the best bargain in each sector. Just make sure you avoid the value traps.

By finding the stocks that are selling at "fire sale" prices, you stand to really fire up your


Next: Value Stock-Picking, Week 3: How to Play the M&A Game

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