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Research shows that quality and value are two powerful drivers of stock market profits. After the economic turmoil we've seen over the past year, it's possible that these two factors could have an influence on the Dongguang Chemical (HKG:1702) share price.
For contrarian investors looking for shares that are being overlooked by the market, quality and value are vital clues. Academic studies show that good quality, cheaply priced shares can deliver outperformance on average over time. So it's no surprise that these rules are used by some of the world's most respected investors - from Joel Greenblatt to Warren Buffett.
The Dongguang Chemical share price has moved by 4.35% over the past three months and it’s currently trading at HK$2.40. But what's interesting about this share is its potential exposure to those influential profit drivers of high quality and a relatively cheap valuation.
Here's an idea of where you can see that:
Good quality stocks are loved by the market because they're more likely to be solid, dependable businesses. Profitability is important, but so is the firm's financial strength. A track record of improving finances is essential.
One of the quality metrics for Dongguang Chemical is that it passes 9 of the 9 financial tests in the Piotroski F-Score. The F-Score is a world-class accounting-based checklist for finding stocks with an improving financial health trend. A good F-Score suggests that the company has strong signs of quality.
While quality is important, no-one wants to overpay for a stock, so an appealing valuation is vital too. With a weaker economy, earnings forecasts are unclear right across the market. But there are some valuation measures that can help, and one of them is the Earnings Yield.
Earnings Yield compares a company's profit with its market valuation (worked out by dividing its operating profit by its enterprise value). It gives you a total value of the stock (including its cash and debt), which makes it easier to compare different stocks. As a percentage, the higher the Earnings Yield, the better value the share.
A rule of thumb for a reasonable Earnings Yield might be 5%, and the Earnings Yield for Dongguang Chemical is currently 40.8%.
In summary, good quality and relatively cheap valuations are pointers to those stocks that are some of the most appealing to contrarian value investors. It's among these shares that genuine mis-pricing can be found. Once the market recognises that these quality firms are on sale, those prices often rebound.
What does this mean for potential investors?
Finding good quality stocks at cheap prices is a strategy used by some of the world's most successful investors. But be warned: these factors don't guarantee future returns and we've identified some areas of concern with Dongguang Chemical that you can find out about here.