Why Value Investing Helps Investors Through Market Swings

With swings in stock market prices becoming bigger and valuations still rather lofty, some investors remain jittery about getting into the market at these levels.

Flat-to-weaker returns and a slowing global economy have some investors wondering if they should just park money in cash rather than equities. But there are still ways to play the stock market despite concerns about valuation and volatility, and that's by value investing.

Value investing hasn't been easy in a market with high prices, say market watchers, and like any investing method, it goes in and out of favor depending on market cycles. But over the long run, value investing is a way to buy low.

Value investing follows the theory that stocks with a low price-to-book ratio outperform growth stocks over the long term. It is in part based on research by Nobel Prize-winning economists Eugene Fama and Kenneth French, whose work is known as the three-factor model.

John Buckingham, chief investment officer of AFAM Capital and editor of The Prudent Speculator investment newsletter in Aliso Viejo, California, says since most people seek bargains when they buy, value investing should make sense. But it is difficult to convince people to do so.

"The same principles should apply to investing. ... Unfortunately, the stock market is one of the few places where people tend to be more comfortable to buy things that have gone up in price. The expectation is that things will continue to go up in price," he says.

Most investors won't buy stocks when they're out of favor, says Mark Travis, president, chief executive officer and chief investment officer of Intrepid Capital Management in Jacksonville Beach, Florida.

"It's a psychologically difficult way to manage money because you have to buy something after it's gone down. It's not infrequent that the stock might go down some more before it goes back up to its valuation," he says.

The difference been cheap and value. Just because an investment is cheap doesn't necessarily make it a good value. Investors need to dig into the company's balance sheet and be cognizant of what's going on in the firm's broader industry before buying, Travis and Buckingham say.

In addition to the price-to-book value, or the net worth of a company, Buckingham says he looks at a few other metrics, including a firm's price-to-earnings and price-to-sales ratios. He also considers how much debt a company carries versus total assets, and when the debt is due.

Kevin Holt, chief investment officer of U.S. Value Equities at Houston-based Invesco, says price-to-book values are especially important when trying to value commodity-focused firms, rather than using price-to-earnings ratios, because a firm's earnings are based on commodity values.

"P/E ratios are going to look really low when the commodity price is high, and they're going to look really high when the commodity price is low. It doesn't matter if it's a steel stock or an oil stock," Holt says.

Oil companies have good value now. Holt says in the commodity sector, integrated oil companies offer the best value now. Oil companies are hurting due to the excessive current global production and low oil prices, but Holt says that's a temporary phenomenon.

"Ultimately, the key issue on a long-term basis is we don't have that much excessive [oil] supply," he says. "[Company] valuations haven't been this cheap relative to the market price-to-book relative to the [Standard & Poor's 500 index] since the 1930s."

The risk in buying oil companies now is that the cycle could last a little longer, he says. Two companies to consider are Chevron Corp. (ticker: CVX), which has a dividend yield of 4.7 percent, and BP (BP) with a yield of 7.7 percent -- both stocks that Invesco owns now.

Also in the commodity sector, Buckingham says he likes earth-moving company Caterpillar (CAT) and fertilizer company Mosaic (MOS). They have yields of 4.5 percent and 3 percent, respectively, and he owns these companies.

Caterpillar is a company that has weathered good and bad cycles, he says, and it is likely be able to access credit markets much easier than "a startup company that spent all of its money on a sock puppet. There is no magic bullet that says CAT won't have more problems. And there are some people who are betting that CAT will have more problems. That's what makes the stock market."

Mosaic is a long-term investment, too, Buckingham says. "We live in a world that needs to feed itself. ... We need to become more efficient with existing farmland we have. Fertilizer is one of the primary ways land becomes more efficient," he says.

The company's share price is down 35 percent, "but their earnings have not been hit hard. That's the interesting thing," he says.

Three additional picks to buy. Travis says there are three companies he owns that he says represent good value now. Defense contractor American Science & Engineering (ASEI) is a small firm that creates scanning machines used by the U.S. military in Iraq and Afghanistan, among other applications. It has 4.8 percent dividend, $87 million in cash and no debt.

"I think this is a perfect tuck-in acquisition for a Northrop Grumman Corp. (NOC) or General Dynamics Corp. (GD)," he says.

On the energy side, he likes Patterson UTI-Energy (PTEN), which has land-based oil-drilling rigs and a pumping business used in hydraulic fracturing. "They've been swung around by the price of crude oil, and it's created a dislocation," he says. It has a 2.7 percent dividend yield.

His final pick is The Western Union Company (WU), with a dividend of 3.4 percent. While the company has some competition in the space, he says Western Union "spits out $1 billion in free cash flow every year."

Travis cautions investors who are looking at value stocks to remember that these are long-term investments rather than short-term plays. "Any investment style will come and go out of favor. What's important is will you stick with it? I think what value investing is offering is not a free lunch, but a defensive way to protect and grow your capital base," he says.

Debbie Carlson has more than 20 years experience as a journalist and has had bylines in Barron's, The Wall Street Journal, the Chicago Tribune, The Guardian, and other publications. Follow her on Twitter at @debbiecarlson1.