10 cheap stocks for contrarian value investors

Knowing what to look for in a cheaply priced share plays a vital role in any value investing strategy. While most investors don't have the advantage of accountancy training, there are a few shortcuts to help understand a company's valuation and its business quality.

For the most part, relative valuation is done by comparing a company's share price against either what it earns or what it owns. The aim of the value investor is to buy assets on the cheap or earnings on the cheap. And there are several ratios to help try and figure this out.

Ratios like price/earnings (P/E), price/cashflow (P/CF), dividend yield, EV/EBITDA and price/sales (P/S) all aim to judge price against what a company earns. Meanwhile, the price/book (P/B), price/tangible book, price/net current assets, price/cash (P/C) and so on, all compare a share's price against what it owns.

Over time, these ratios come in and out of fashion. For instance, back in the late 1990s, the price/sales ratio became a very popular way of valuing dotcom companies with no earnings.

During recovery phases in the stockmarket, the biggest bargains and best performances have been found using asset based measures like price/book and price/cash. In recent years, low interest rates have meant that the dividend yield has been among the most successful value metrics.

An all-weather approach to value

This is all very well, but how can you apply value investing in a strategy designed for all stockmarket seasons? One solution is to use the approach of an investor like James O'Shaughnessy. He runs the fund firm O'Shaughnessy Asset Management and wrote the influential investment book, "What Works on Wall Street".

In his research, O'Shaughnessy explains how to build a composite value score for every stock in the market that blends a set of six value ratios - P/S, P/E, P/B, P/CF, EBITDA/EV, and yield.

Instead of relying on one value ratio, O'Shaughnessy found that ranking every stock against every ratio and creating a composite score, produced superior results. For example, between 1964 and 2009 - using P/S alone - the cheapest 10% of stocks picked by their P/S ratio returned 14.49%. But by using the composite value rank instead, the return was improved to 17.3% with less risk.

Ranking the market for the cheapest shares

At Stockopedia we have a similar technique to create a ValueRank for every company (from 0 - expensive to 100 - cheap). This means it's possible to focus on the cheapest companies in the market across a range of ratios. Like any value investing strategy, this approach is likely to find a list of the most troubled companies around. But it's an ideal starting point for contrarian value hunters to look for possible mispricing.

This list of ten companies (those worth more than £10 million) with the highest Value Ranks contains some well-known names. In many cases, these firms will be facing difficult trading conditions and the market will be wary of whether their problems can be overcome.

Stocks like Game Digital, Trinity Mirror, Debenhams and SCS have faced well documented problems. By contrast, others like Marshall Motor Holdings, the car dealership group, and marketing firms like Communisis and Mission Marketing may be facing cyclical market lows or uncertain macro conditions.

Whichever way you look at it, digging around among the cheapest stocks in the market isn't for the faint hearted. Often these companies have uncertainty surrounding their financial strength or business viability. So wide diversification is essential in order to harvest the deep value premium and absorb the inevitable losses.

In the decades since 'value' came to the fore as one of the most powerful stockmarket return drivers, numerous financial ratios have been used as a measure of what's cheap. But rather than relying on a single measure, a value composite using several value factors could be a more effective way of navigating one of the trickiest - but lucrative - parts of the market.

About Stockopedia

Interactive Investor's Stock Screening series is written by Ben Hobson ofStockopedia.com, the rules-based stockmarket investing website. You canclick here to read Richard Beddard's review of Stockopedia.com and learn more about the site.

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It's worth remembering that these and other investment articles on Interactive Investor are simply for generating ideas and if you are thinking of investing they should only ever be a starting point for your own in-depth research before making a decision.

*No fee for publication is involved between Interactive Investor and Stockopedia for this column.

Ben Hobson is Investment Strategies Editor at Stockopedia.com. His background is in business analysis and journalism. Ben researches and writes regularly on investment strategy performance and screening ideas for Stockopedia.com. He is the author of several ebooks including "How to Make Money in Value Stocks" and "The Smart Money Playbook"

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.