It sounds logical enough: Stick with cheap stocks and you're more likely to make money than chasing the next growth story.
That's the idea behind value investing — and it may be especially pertinent in today's choppy market. Investor sentiment is wobbling with the S&P 500 (.SPX) down around 5% this year. And after last year's steep climb in stock prices, investors may be growing more sensitive to valuations.
The trick to making money now is to have "realistic expectations," wrote portfolio managers Wallace Weitz and Bradley Hinton of Weitz Investment Management in a recent letter to shareholders. Weitz and Hinton are well-known value investors who follow the Warren Buffett school of stock picking. Given today's high valuations, they added, "it would not be surprising if stock prices grew slower than the underlying businesses in 2014 as values 'catch up' with prices."
The question, of course, is where to find the best bargains.
One place to look is sectors that appear cheaper than the rest of the market, based on measures like book-to-price ratio, a gauge of a company's net worth relative to its stock price. Financials, energy and health care look comparatively cheap based on that and other valuation measures, according to Russell Investments, which gives those sectors the most weight in the Russell 3000 Value Index.
Avoiding value traps
Yet while these sectors may appear inexpensive, they may not represent the best bargains. Some analysts think the technology sector now looks exceptionally cheap, trading at a 32% discount to its average P/E ratio over the last 15 years, according to JP Morgan Asset Management.
But a stock with a low book-to-price ratio can be a value trap. Many large banks and other financial stocks looked cheap based on their book values heading into 2008. Yet their stocks plunged as the value of their mortgage-backed securities and other financial assets collapsed.
Because of these issues, analysts look at other measures to determine a stock's value, and they factor in Wall Street opinions — looking for stocks that are beating estimates and showing earnings momentum.
"If a stock price isn't improving or analysts aren't raising their estimates, the stock is dead," says John Kozey, director of research with KnowVera, a trading and research firm in Danbury, Conn.
To find compelling investments, we used screening criteria developed by research firm StarMine. The screen used StarMine "smart" estimates that attempt to compensate for biases in analysts' forecasts. It also filtered stocks by a variety of valuation and growth measures, including historical comparisons, and it layered in momentum factors, including changes in earnings estimates, analyst ratings and stock prices.
"Value is wherever you can find it," says Kozey, who ran the screen for us. "I look for stocks with as many attractive characteristics as possible so that if something goes wrong with one, the others can keep it from turning into a disaster."
The following five stocks earned the highest scores in our screen. Keep in mind, however, that they aren't without risk: They can be quite volatile, and investors should view them as a starting point for further research rather than as recommendations.
Based in Seattle, Alaska Air (ALK) is benefiting from a rebound in air travel: More of its flights are fully booked and it's generating more sales from passenger fees.
Competition is rising, though, especially in the airline's home market of Seattle, where Delta Air Lines (DAL) is making a big push.
Yet Alaska Air still managed to expand its profit margins over the past year. Earnings per share climbed 15% in 2013 and could jump 28% this year, according to Wolfe Research analyst Hunter Keay. The stock looks cheap, moreover, trading at a 35% discount to the S&P 500 (.SPX), he wrote in a recent research note.
Key risks: Higher fuel costs would impact the airline's profits. The stock could slump due to a slowdown in air travel or more intense price competition.
ConocoPhillips (COP) went on a buying spree in recent years to expand its North American oil-and-gas production. Profits have slumped as its debt costs have climbed.
But it now has a leading position in the domestic energy industry, according to Barclays analyst Paul Cheng. And it should become more profitable as it gradually sells less profitable assets and ramps up domestic drilling.
Analysts expect the Houston-based firm's earnings per share to slump 27% this year but rebound 9.9% in 2015. The company could also raise its dividend, which accounted for 44% of profits in its last fiscal year and has grown at a 10% annual rate over the past five years, according to Thomson Reuters.
Key risks: Higher oil prices or a drop in gas consumption would hurt profits for the firm.
Rising consumer spending is lifting sales for many department stores and Macy's (M) is benefiting. Earnings per share jumped 11% in 2013 and analysts expect profits to grow 17% this year to $3.80 a share.
Macy's is no Amazon.com (AMZN) — the department store's sales are inching up less than 3% a year. But the Cincinnati-based retailer is taking other steps to boost earnings per share: It recently launched a program to cut $100 million in costs a year, and it's planning to buy back more stock.
The firm could repurchase up to $8.5 billion of its outstanding shares over the next three years, amounting to 44% of its market value, according to BMO Capital Markets analyst Wayne Hood, who recommends the stock.
Key risks: Weaker consumer spending would likely pressure sales and profits. Competition from online retailers is likely to increase.
Oil refineries like Marathon (MPC) make the most money when oil prices are low and gasoline demand is high. Rising domestic production has been positive for refiners since it's helped lower oil prices. And gasoline demand, which has been steady, could improve if the economy keeps gaining strength.
Marathon's stock is sensitive to oil prices and can be volatile. Yet the Findlay, Ohio-based firm has been diversifying into pipelines, which provide steadier income and are less sensitive to commodity prices.
Analysts expect earnings per share to rebound 32% this year, after a 33% plunge in 2013. Overall, the company is "committed to a conservative, long-term growth plan," according to Raymond James analyst Cory Garcia.
Key risks: A slump in oil or natural gas prices would likely pressure the stock.
Seagate (STX) makes hard-disk drives, a technology losing business to "flash" memory in PCs and tablets. But hard drives aren't going away. They're still widely used in PCs, and they're finding new homes in corporate data centers, where there's brisk demand for disk space due to trends such as video streaming and cloud computing.
Profit margins for "enterprise" hard drives are 70% to 80% higher than PC disk margins, according to Pacific Crest Securities analyst Monika Garg.
Analysts expect earnings per share to slump 2% this fiscal year and rebound 16.8% in fiscal 2015. The stock, meanwhile, trades around 10 times earnings, a discount to its growth rate.
Key risks: Hard-disk PC sales could decline faster than expected. Stiffer competition from rivals could hurt Seagate's profitability.
Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com. He does not own any of the securities mentioned in this article.