Value stocks are essential to my investment strategy. The process involves finding shares and analysing their intrinsic value, usually using a discounted cash flow analysis.
My preferred way to perform this calculation focuses on past free cash flow metrics to predict future growth. I usually break the investment analysis down into two stages. The first is a 10-year ‘growth’ stage and the second is a 10-year ‘terminal’ stage. I currently use an 11% discount rate (a percentage used to determine the present value of future money).
What makes value investing so effective is that it provides my investments with a margin of safety. This is a concept made famous by Warren Buffett’s teacher Benjamin Graham, who is often called ‘the father of value investing’.
I do not rely solely on discounted cash flow analysis. Instead, I take into consideration a wide variety of forecasted financial metrics and macroeconomic analyses. I also perform peer comparisons to arrive at investment opportunities that represent a reliable margin of safety alongside realistic probabilities for future growth.
Here’s my current top pick
I’ve found a company that has low momentum, but a high margin of safety, financial strength, profitability and growth. That signals it could be a great investment that others have not yet realised.
The company is RS Group (LSE:RS1). It isn’t currently in my portfolio, but I may add it as a component if my analysis shows me it could give me returns over the next five to 10 years that outsize larger and more popular businesses that may be more fairly valued.
Financials
The margin of safety on a free cash flow basis is 40.4% at the time of this writing. Operating margin has increased from 8.3% in 2010 to 12.8% in 2023. Debt-to-equity is currently 0.28, but the company has issued £0.1 m of debt over the past three years. The debt level is manageable.
The greatest financial risk I have been made aware of is asset growth being faster than revenue growth, which can be a signal of a company losing efficiency. Assets are currently building at 16.9% per year, and revenue at 9.7% over the past five years.
Momentum issues
The greatest lesson needed to navigate this exceptional value and strong financial opportunity for my portfolio will be patience. The stock is not trading at the levels of Tesla or Google. Reaction to the strong financial metrics will take time, but the return should be relatively high when the share price catches up to its strong fundamentals. For comparison, RS Group has a current average volume of 1.3m and Tesla has a current average volume of 120.5m. Those volume metrics represent the average number of shares traded each day over the past 30 days.
Conclusion
RS Group is my current UK value pick for my portfolio, and I am going to keep a watchful eye on it. It seems like an intelligent purchase given such strong financials. It has an exceptional margin of safety based on discounted cash flow analysis and a low level of public interest currently keeps the share price undervalued.
