Fund managers name their ‘secret sauce’ to successful stock picking

“Buy good companies at low prices” has almost become a cliched phrase in the world of fund management – and a strategy many would agree with. 

Value investing takes this idea a little further, with the idea of picking up shares when their intrinsic worth, or their potential, is underpriced.  While this again seems logical, there are many different ways to measure value. 

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But how do DIY investors gauge value, and what metrics can they use? We have looked at the measures and techniques some of the professionals put to work, and what DIY stock pickers can take from this. 

Basics and less basics 

There are very basic metrics investors can use when trying to identify a “cheap” share. 

There is the price to earnings ratio (share price divided by earnings per share) , which gives a very rough idea of the valuation. And where relevant there is the share price dividend yield, with figures of more than 5% beginning to look enticing and double-digit yields looking particularly juicy – in theory. 

Of course, due diligence and caution need to be applied here. 

A company’s  PE ratio needs to be judged in a relevant context, for example by comparing it versus the ratio of the underlying market, but also versus its sector and its closest rivals. 

Investors can also look at how the trailing PE ratio compares with the forward PE ratio, to gauge whether analysts think earnings will recover relative to the price over time. 

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Moving past those fundamentals, fund managers with a value investment style have their own way of looking for cheap stocks. This can involve some very proprietary techniques that could prove hard to replicate – but might still provide some inspiration for DIY investors. 

Tricks of the trade 

To start with one of the value funds very much in vogue, Temple Bar Ord (LSE:TMPL) co-manager Ian Lance attempts to look into the future rather than dwelling on a company’s past performance. 

“Rather than focus on where earnings were last year or next year, we try to gauge where they will get back to on a five-year basis and we refer to these as normalised earnings,” he says. 

“In addition, we will try to estimate the actual cash available to equity holders as opposed to accounting earnings.  

“For instance, if a business has a large pension fund deficit that needs to be reduced, that will reduce the cash available to shareholders and hence we would adjust for this in our normalised cash earnings estimate.  

“Conversely if a business is over-capitalised and has either cash or investments on the balance sheet that are not required for the normal functioning of the business, that might positively impact our normalised cash earnings estimate.” 

It’s worth acknowledging that DIY investors may find some of these approaches hard to implement. 

But financial metrics are readily available online.

To start with what we offer, ii customers can access a variety of tools when logged in. The research section on an account page gives access, for example, to a share screener which can filter for PE ratios on equities across various markets. 

Fund and trust screeners in the same section can give performance metrics, but also measures of “alpha” (outperformance generated versus the market) and 52-week price highs and lows.

An instrument page for a given share will meanwhile provide a fair value estimate, while an insights section on the site provides Morningstar research as well as our Trading Central insights and eyeQ signals analysis.

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Customers can meanwhile find other tools online, from the key metrics around a stock to sentiment.

If we look at one example, turnaround story Diageo (LSE:DGE) comes with plenty of metrics available online. 

An online search would tell investors its recent PE ratios (18.2 times trailing and 11.8 times forward), other ratios such as prices to sales and price to book, dividend figures, its cash flow, debt, and expected price earnings growth over a five-year period. 

Similarly an artificial intelligence (AI) tool can summarise some of the key metrics and what they mean, including the fact that the trailing PE is “not particularly cheap”, although the dividend yield is much higher than before thanks to the tumble in the company’s share price. 

Investors do understandably like to combine metrics with their instincts, and their sense of a narrative. 

With Diageo, much of the focus will remain on chief executive Dave Lewis and his plans. The former Tesco (LSE:TSCO) chief executive is due to give more details of his strategy for the Guinness, Don Julio and Johnnie Walker owner when he presents annual results on 6 August.

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Other metrics 

Hugh Sergeant, an experienced value manager who works on the RGI UK Recovery B Acc (BVDCTZ7) fund, says: “The key valuation metrics we focus on looking at are longer-term indicators of value, including enterprise value to sales and enterprise value to invested capital, both versus a company’s history and peers. ” 

He notes: “We use these as they allow for profits being depressed versus history, which is normally the case for recovery stocks.” 

The team also calculates a medium-term intrinsic value for companies it views as recovery plays, “assuming they can return to previous levels of return on capital and margins, and putting a sensible (based on history) earnings multiple on these recovered profits”.  

He lists one example as Marshalls (LSE:MSLH), which supplies hard landscaping, building and roofing products. 

“In the recovery model, Marshalls moves from the 2025 financial year adjusted EBIT (Earnings Before Interest and Taxes) of £56 million and earnings per share of 13.4p to financial year estimate in 2029 (FY29E) of adjusted EBIT of £116 million and earnings per share of 33.6p,” he says.  

“At the current share price used in the model (136.8p, 12 June 2026), that is 4.1  times FY29E recovered earnings per share and 3.7x FY29E enterprise value/EBIT. Applying a modest 10  times recovered earnings per share  or 8 times recovered EBIT cross-check gives a recovered value of  roughly 334–336p/share, or 145% upside.” 

Avoiding the traps 

Value traps are a real threat to any bargain hunter, and seeking companies with defensive traits may limit some of this risk.  

Nitin Bajaj, portfolio manager on the value-oriented Fidelity Asian Values Ord (LSE:FAS) fund,  likes Professor Joel Greenblatt’s “magic formula” approach, which focuses on “buying good businesses at prices that offer a substantial margin of safety”. 

Bajaj looks at companies with a high return on equity to provide some measure of quality but that also trade on a low PE ratio. 

Companies that score well on both metrics would then look appealing to him if they were run by “capable and honest management teams”, with good businesses being ones that can solve a problem for their consumers. Once again, this does combine metrics with some instinct, and some more qualitative assessment. 

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Other managers asked about their process in the hunt for value have talked about doing their own number crunching. 

Jack Barrat, who works on the Man Undervalued Assets Profl Acc C (BFH3NC9) fund, notes that the team looks at the metrics of cash return on net tangible capital employed, the incremental return on capital employed, and the all-in enterprise value as a multiple of the tangible capital employed. 

“We manually calculate each of these metrics for every company we look at,” he says. “Often our view of fair value differs markedly from the wider market.” 

There are multiple reasons for this. 

To give one example, with the cash return on capital employed, the Man team looks at “the actual cash generated by the business normalising for capital expenditure, contract-based accounts, exceptionals, share-based payments and many other things”, an approach that can make companies less profitable than company management or broker research might suggest. 

Not all these strategies will be available to DIY investors. But they do point to the nuance involved in hunting for value – and the need to really dig into detail where possible.