There are a variety of value investing fundamentals that savvy investors look for when picking stocks, including hidden assets

There are numerous reasons why a value stock can be underappreciated and inexpensive. One common reason is a company may have temporarily experienced reduced sales due to bad publicity, legal issues, or simply because it has lagged behind its competitors.

Whatever the reason, a value stock could be ignored by most investors. However, Successful Investors—looking at the stock’s value investing fundamentals—recognize that it has strong potential to bounce back and make a bigger impact in the market.

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Hidden assets are one of the key value investing fundamentals to keep an eye on

Value stocks are stocks trading lower than their financial fundamentals suggest. They are perceived as undervalued and with the potential to rise.

For a long time, we’ve written about the “heads-you-win-tails-you-break-even” phenomenon. That’s what you get with an investment that exposes investors to limited risk of long-term loss, but one that can deliver healthy if not substantial returns.

These situations sometimes come about when a stock has been an unimpressive or weak performer for a number of years. When that happens, investors often focus on the earnings weakness and lose sight of the company’s assets. And key among those assets are “hidden” ones.

Most investors overlook hidden assets. The classic example is real estate that is worth a lot more than its balance-sheet value (which is usually the purchase price, minus depreciation on the buildings).

Another source of hidden value is successful research and development spending. These outlays get written off against current-year income, much like day-to-day expenditures, including rent and utilities. This accounting treatment depresses current earnings. But if the research turns up anything of value, it adds to long-term profit.

If you buy a stock for its hidden assets, but those assets stay hidden or ignored by investors—or turn out to be less valuable than you thought—it can’t hurt your investment. By definition, a stock’s hidden assets have not had much impact on its price. If you paid little if anything for the assets, you have little to lose. But the best hidden assets will eventually expand a company’s profit, grab investor attention, and push up its stock price.

Identify hidden assets early for maximum gains

The best time for Successful Investors to find hidden assets is long before the company begins taking steps to profit from them. Understanding and seeking out hidden assets while you’re evaluating a stock can add enormously to your profits over the course of an investing career. But you need patience to profit from them, because they can stay hidden for a long time after you buy.

Hidden assets can also cut your risk. Stocks with hidden assets are likely to hold up better than those whose assets are easier to spot, since they are the last stocks that Successful Investors sell. When times are good, on the other hand, stocks with hidden assets tend to do better than average. Good times give them an opportunity to put their hidden assets to work.

Take a broad approach to your value investing—don’t zero in on just one indicator

When they choose stocks, many investors try to cut their workload by taking a narrow view. Rather than look at a wide range of information, they prefer to zero in on one or at best a handful of indicators. This can do more harm than good.

For instance, many investing newcomers get the idea that you should only buy stocks that trade at a below-average p/e ratio (the ratio of a stock’s price to its per-share earnings). Some go so far as to reject any stock that trades above some arbitrary cut-off, such as 10 times earnings.

However, this might very well ensure that you avoid some stocks at precisely the best time to buy or buy others that you should avoid.

Another problem with focusing on low-p/e stocks is that many disasters-in-waiting go through a low-p/e period prior to their eventual collapse. This low-p/e period occurs because people close to or involved with the company recognize that it has serious problems. They sell their own holdings, and they tell their friends and relations to do the same.

To get any real value out of p/e’s, you have to look at them in the context of everything else that’s going on, in the market and in individual stocks.

Bonus Tip: More investing fundamentals to watch for

Here are some criteria to look for in stocks for your diversified Successful Investor portfolio:

• 5 to 10 year history of profit.
• 5 to 10 years of dividends.
• Manageable debt.
• Industry prominence if not dominance.
• Freedom from business cycles.
• Ownership of strong brand names and an impeccable reputation.

Have you invested in what you thought were value stocks only to find they were value traps in disguise?