Don’t miss these three key steps to identifying TSX value stocks—those low in price relative to their high potential

Some investors only feel safe buying stocks after prices have risen, which means that they often overlook TSX value stocks (penny stocks). Yet this is the opposite of the way you make most purchases (cars, clothing, etc.). Ordinarily, it’s better to buy when prices go down, not up. When buying stocks, you’ll find this same logic applies.

TSX value stocks are companies that are undervalued on the Toronto Stock Exchange. In the past, some examples we have suggested as noteworthy TSX value stocks  include Calian Group (Toronto symbol CGY; www.calian.com), Canadian Tire (Toronto symbol CTC.A); and Bank of Montreal (Toronto symbol BMO; www.bmo.com).

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Take these three steps to find profits in TSX value stocks

When investing in any stocks, and not just TSX value stocks, you’ll rarely if ever sell near the top, or buy back near the bottom. If you could do that with any consistency, you’d “make all the money in the world,” as the saying goes. And no one ever does that. The same applies, especially, for penny stock investors seeking to get in “on the ground floor” by picking a value stock (tsx) and taking the stock’s hoped-for gains all the way to the top.

Instead, the best way to identify the most undervalued stocks on the market and make long-term investment profits—including on so-called penny stocks with strong prospects—is to follow these basic steps and financial factors for finding the best TSX value stocks to invest in:

Step 1 for investing in TSX value stocks: The first step to finding TSX value stocks is to visit the websites of the companies you are interested in investing in. Get on their mailing lists, and read their quarterly and annual reports. Ask your broker for research reports. (Note: this level of research may be more difficult with penny stocks or a thinly traded value stock (tsx.) Read the business news every day. You’ll be less liable to get caught off guard by price fluctuations and over time you’ll begin to spot the most undervalued stocks in a lineup simply through observation.

Based on this data, look at these financial factors when searching for a value stock (TSX):

• 5 to 10 year history of profit. Companies that make money regularly are safer than chronic or even occasional money losers.
• 5 to 10 years of dividends. Companies can fake earnings, but dividends are cash outlays. If you only buy dividend-paying value stock picks, you’ll avoid most frauds.
• Manageable debt. When bad times hit, debt-heavy companies go broke first.

Step 2 for investing in TSX value stocks: In addition to getting to know the companies you invest in, including penny stocks, you should also get to know the industries that stocks operate in. Some industries are more volatile than others. Don’t invest in industries you’re not familiar with, and you’ll steer clear of many overvalued stocks.

Based on this data, identify these safety factors when looking for a value stock (tsx):

• Industry prominence if not dominance. Major companies can influence legislation, industry trends and other business factors to suit themselves. Minor firms, on the other hand, don’t have that power.
• Geographical diversification. Canada-wide is good. There’s extra risk in firms confined to one geographical area.
• Freedom to serve (all) shareholders. High-quality value stock picks must be free of excess regulation, free of dependence on a single customer, and free from self-dealing insiders or parent companies.

Step 3 for investing in TSX value stocks (or penny stocks): Consider earnings, dividends and other factors in making decisions. They matter far more than short-term stock-price trends. Stock prices rise and fall. But strong dividend stocks like to ratchet their dividends upward. Even during market downturns, the last thing a well-established company is likely to do is lower its dividend. When times are good, strong companies will raise their dividends.

Based on this data, identify these growth factors:

• Freedom from business cycles. That’s why you need to diversify. Invest in utility, finance and consumer stocks, along with resources and manufacturers.
• Ability to profit from secular trends: These trends outlast ordinary business booms and busts, because they reflect ongoing social change. Free trade and rising environmentalism are just two examples of secular trends.
• Ownership of strong brand names and an impeccable reputation. Customers keep coming back to these businesses, and will try their new products.

Rely too much on simple value measures alone in stock analysis and you could fall into a costly value trap, even when focused on finding a value stock (TSX)

You need an eye for value to be a Successful Investor. You can gain that eye by subscribing to our newsletter Canadian Wealth Advisor now. But focusing on value measures alone can steer you into unsuccessful investments that are sometimes referred to as “value traps.” Note that this publication steers you clear of the kind of penny stocks that offer little more than speculative value, at that.

Another way to fall into a value trap is to put too much faith in the value of a brand name. A strong brand can sell a lot of a strong product, or keep an over-the-hill product going long after competitors have faded. But even the strongest brand name can only do so much.

4 tips for avoiding value traps when picking a value stock (TSX):

1. Determine if the company has freedom from business cycles. Demand periodically dries up in “cyclical” businesses such as resources and manufacturing. You can hold some value stocks from those sectors, but look as well for companies, especially in manufacturing, that have broad product lines or products that are indispensable.
2. Review a company’s dividend record over the last 5 to 10 years. Companies can fake earnings, but dividends are cash outlays. If you only buy dividend-paying stocks, you’ll avoid most frauds.
3. Review a company’s finances going back 5 to 10 years. The types of investments we focus on have a history of profits going back for at least that long. Companies that make money regularly are safer than chronic or even occasional money losers.
4. Determine if the company has hidden assets in their relationship with loyal customers. After a series of satisfactory dealings, long-time customers develop a level of trust that makes them receptive to related offerings from the company. This customer loyalty can help businesses mitigate the value trap.

Bonus Tip: Consider investing at least some of your funds by practicing “dollar cost averaging.” Invest the same dollar amount on a regular basis. That way you’ll buy more shares when prices are low, and fewer when they’re high.

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In fact, if you invest a fixed sum at regular intervals throughout your working years, perhaps increasing that sum from time to time as your income rises, you can largely forget about market trends. If you factor in dividend payments, dollar cost averaging could make a huge difference to your long-term profits.

Are you willing to wait for a value stock (TSX) to reach its full potential, or will you look for stocks that rise faster? How does that approach apply to penny stocks?

Which value stock has been the biggest overachiever in your portfolio? The biggest loser?

This article was originally published in 2017 and is regularly updated.