Investing in out of favour stocks would be much easier if there were dependable identifying characteristics of either the companies or the share prices. For example, it would be lovely to think that Directors buying shares in their own companies or companies buying back shares was a foolproof approach to pinpointing share price lows. Similarly, it would be lovely if there was a certain feature on a share price chart or a valuation indicator such as price earnings ratio or dividend yield which was consistently useful.

Unfortunately and not surprisingly no consistent approach has yet been found for successfully avoiding all falling knives whilst embracing fallen survivors.

Because of this, many investors prefer to wait for catalysts. This might be better trading news, the arrival of new management or a certain stockbroker to turn more bullish. We have found these indicators similarly frustrating as typically they just result in paying a higher price for the share with no guarantee that fundamentals have really changed for the better.

So if no-one rings a bell or waves a flag at the bottom and there is no foolproof method for picking the winners from the losers, what is our approach?

Firstly, we prefer to assess what the long-term profitability of the company is and decide what the market would be willing to pay for that level of profitability. However, we then need to try and assess the probability of the company making those profits. There are typically two stumbling blocks for this approach: the risks that a company might be unable to trade through its tougher times because of a weak balance sheet and the risks that our assessment of long-term profitability is significantly wrong.

UK house builders offer a useful case study at the moment. Clearly the UK housing market is horrible at the moment but historically if we had waited for the arrival of a clear improvement in trading news that would have proved much too late to buy the shares. We are tempted to buy the sector. Undoubtedly, trading news will get worse from here, we may see land values being written down quite significantly and company management may become more negative. However, the shares have already discounted a lot of bad news and some shares in the sector trade at below their asset values but against that we know the industry is cyclical and good times will ultimately return. And historically in those good times, the market has been happy to pay a large premium to asset value for the shares.

This article is not investment advice or a recommendation to buy any share or fund mentioned directly or indirectly, and should not be relied on in making any investment decision.

Please note that the opinions expressed in the above article are the opinions of the author alone, and do not necessarily represent the views of Investec Asset Management or its associated companies.

Investec Asset Management, or any of its associated companies or employees (including the author), may hold positions in any of the securities mentioned in the above article or in related securities.