Value Investing
The easy way

by Ann Coleman (TMF

Alexandria, VA (March 2, 1999) -- Growth investing is the buzzword these days, while value investing seems to be getting short shrift. These two investing styles have been alternately in and out of favor for decades.

Since naturally everyone wants their investments to grow and, likewise, everyone wants their investments to be a good value, we should probably define those terms.

Value investing looks for stocks that are underpriced -- cheap, even. Finding a stock that is selling for about half of what it "should" be selling for (based on the investor's assessment of its intrinsic value) is what value investors dream of.

Growth investors are less concerned about getting a bargain and more concerned about a company's growth potential. They look for companies whose sales are increasing rapidly (remind you of any online bookstores you know?) or whose EPS are growing at 25% a quarter. Growth investors are less concerned about the current price because they expect the company's rapid growth to make up for any initial overpayment. There is a limit to that, of course, but generally, growth is given much more emphasis than price. (Our Rule Breaker Portfolio is very big on growth stocks, but even it has a Foolish Four component to act as ballast for the high flyers.)

Of course, the two styles are not mutually exclusive. Experienced individual investors often try to balance their portfolios to include both. And everyone likes a fast growing company that is way underpriced. But these two styles have a tendency to alternate, with value stocks being more popular for a few years and then growth stocks coming into favor for a while. In fact, that cycle is so pronounced that one investing strategy recommends buying growth-oriented mutual funds when value-oriented funds are in vogue and vice versa in order to profit from the "inevitable" swing that brings what is down back up again.

I'm not in the business of predicting market swings, but I do find that notion interesting. Today's market darlings, Internet and technology stocks in particular, are very much growth stocks. Mostly you hear about how they are going to dominate the market in the next century. The Foolish Four is definitely on the value side of this great divide.

Even though it is a mechanical strategy that doesn't require investors to develop any kind of intrinsic valuation (what, no price/sales ratios? No free cash flow analysis?!), the Foolish Four's formula is designed to identify underpriced stocks -- that is, value stocks.

Remember, a stock with a low price is not cheap. A stock whose price is low relative to its intrinsic value is cheap. So a $10 stock may be much more expensive than a $300 stock, if that $10 share is really only worth only $5 and the $300 share is really worth $400. Figuring out a stock's intrinsic value is, of course, the hard part.

That's where the Foolish Four comes in. By limiting itself to a small universe of large, highly successful companies (this is key), the Foolish Four's formula identifies a small subset of stocks that are likely to be underpriced -- based not on price (our second best performing stock so far this year is our most expensive!) but on the relationship between price and dividend yield.

The second act for value investors is, of course, for the market to recognize what they knew all along -- that this stock is really quite a bargain. The market collectively smacks its forehead -- how could they have overlooked Amalgamated Dental Fillings? And the rush is on, with the value investor well rewarded for his patience and foresight.

Tomorrow we will discuss just exactly how the Foolish Four's formula works to identify value stocks.

Fool on and prosper!

Make a Living Foolin' Around.

 Recent Foolish Four Portfolio Headlines
  12/28/00  Modifying Mechanical Strategies
  12/27/00  Beating the S&P Year 2000 Recap
  12/26/00  After-Hours Quotes
  12/22/00  Why Include the Foolish 4 Port?
  12/21/00  The Value of Community Input
Foolish Four Portfolio Archives »  

Today's Stock Lists | 1998 Dow Returns

03/02/99 Close
Stock  Change   Last
CAT  -1  3/4   47.44
JPM  +   7/16  112.06
MMM  +  13/16  74.38
IP   -   9/16  40.38

                   Day   Month    Year   History
         FOOL-4   -0.94%   0.47%   1.49%   3.00%
        DJIA     -0.29%  -0.10%   1.42%   1.02%
        S&P 500  -0.86%  -1.04%   0.02%   0.26%
        NASDAQ   -1.58%  -1.27%   3.03%   4.44%

    Rec'd   #  Security     In At       Now    Change

 12/24/98   24 Caterpillar   43.08     47.44    10.11%
 12/24/98    9 JP Morgan    105.51    112.06     6.21%
 12/24/98   14 3M            73.57     74.38     1.09%
 12/24/98   22 Int'l Paper   43.55     40.38    -7.29%

    Rec'd   #  Security     In At     Value    Change

 12/24/98   24 Caterpillar 1034.00   1138.50   $104.50
 12/24/98    9 JP Morgan    949.62   1008.56    $58.94
 12/24/98   14 3M          1030.00   1041.25    $11.25
 12/24/98   22 Int'l Paper  958.12    888.25   -$69.87

              Dividends Received      $15.04
                             Cash     $28.26
                            TOTAL   $4119.86