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Quality and value are two important drivers of stock market returns - yet many investors fail to take them seriously. At a time of deep economic uncertainty, using these two powerful factors to find stocks could help you navigate market volatility.
The Serica Energy share price has moved by -14.3% over the past three months and it’s currently trading at 289.5p. But what's interesting about this share is its potential exposure to the influential profit drivers of high quality and a relatively cheap valuation.
This matters because at a time when many investors are on the lookout for cheap shares, it's important to know the difference between a genuine bargain and a value trap. The secret is that it's often the quality of the stock that makes all the difference. While no stock is immune from a sudden setback, focusing on quality and value is what some of the world's best investors do.
Here's where that difference shows up:
Quality you can depend on
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 Serica Energy 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.
Buying at a fair price
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 Serica Energy is currently 36.3%.
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 Serica Energy that you can find out about here.