Tuesday, June 15, 1999
Waiting for Value
I've mentioned this investing philosophy before, but I'll repeat it since many people are more attentive after suffering a little pain than when enjoying the benefits of a buoyant market. You don't have to jump into that "Gotta Have It" stock when everyone wants it. If you think that a security has achieved a valuation level that is unwarranted based on reasonable expectations about future results, hold off and evaluate other opportunities. You shouldn't forget the stock; simply put it on a watch list to follow and buy it when the price becomes a little more reasonable. Although it doesn't always happen, some event almost always intervenes at some point to disrupt an upward price trajectory.
The recent downturn in Internet stocks and drug stocks demonstrates the point that "a cooling off period" will occur in even the hottest sectors. Since April, many of the leading Internet names have been halved. Yahoo! (Nasdaq: YHOO) is down 49%, Amazon.com (Nasdaq: AMZN) has fallen 56%, and "blue-chip bellwether" America Online (NYSE: AOL) has been hit for a 46% loss. The upward pressure that was driving these stocks forward at unprecedented rates has (at least temporarily) abated. Many of the lesser known names have fallen much further: Ticketmaster Online (Nasdaq: TMCS) is now trading at $25 1/2, off 64% from its high late last year and Critical Path (Nasdaq: CPTH) is hovering at less than a third of its high just over two months ago.
You will notice that I have "framed" all of these companies from the perspective of how much they have fallen since their peaks, which is really quite unhelpful. Just because a stock price has dropped (even substantially) does not mean a bargain is to be found. That would be like saying that a $100 handkerchief from your friendly Needless Markup department store is a good value when it is part of a 50% off sale. Even though the price is reduced to $50 per preppy accessory, I would pass on the deal. If I needed the product, I would be satisfied picking up a 6 pack for $3.50 from Ross Stores (Nasdaq: ROST). Much more important than "how much has the stock fallen" is where the price lies relative to whatever valuation tools and metrics you prefer to use.
There are no necessarily right or wrong valuation tools that you should use. Although one of my favorites is the price/earnings ratio relative to growth (a.k.a., the Fool Ratio), many others prove useful in different industries. In cable, you might look at Enterprise Value/EBITDA (earnings before interest, taxes, depreciation, and amortization) or price per subscriber. For Internet firms, value per unique visitor has emerged as a valuation tool. In addition to these metrics, it is helpful to check out the balance sheet to find out your company's debt level and glance at the cash flow statement to determine the relationship between reported earnings and operating cash flow. Comparing the financials of your target company with those of other firms in its industry, as well as the industry vis-a-vis the overall market can also be enlightening.
Once you have developed your valuation strategy, apply it to potential investment candidates. Over time, you will probably find that your perspective and philosophy evolves based on your increased experience. That's healthy as long as you realize that many phenomena are not perpetual. For example, stocks of smaller companies will not always lag the performance of larger firms, despite what has happened over the past few years. I can't tell you when the performance disparity between the two classes of stocks will change, but sometime over the next two decades it will.
If a stock price doesn't jive with what you consider to be a reasonable valuation, chill out and wait for something to happen that brings it into what you feel is a more appropriate level. You will have years to accumulate a stake in a good pick for a Foolish portfolio. Great companies are made of strong results for decades, not a year or two. Over time, the stock you're evaluating will likely fall within your valuation parameters several times. Sometimes it will hit your comfort zone because reported results far exceed your expectations, raising the price you are willing to pay. At other times, the company will fall out of favor because of political threats (like the pharmaceutical sector in 1993-1994 and again today). Then again, stock prices sometime change dramatically for no reason at all. It just happens. If you feel confident about the company's prospects and the price is fair, scoop it up.
Personally, I recently have seen many companies that at one time were out of my valuation thresholds come into buying range. Although I was challenged to find any reasonably priced biotechs in the early 1990s, several great companies are now within my value parameters. Many pharmaceutical stocks have traded at levels higher than where I would purchase them for a couple of years, yet I can now find many that are appealing. I felt that small casual dining restaurant chains were way overpriced in their 1994-1995 heyday, but they look quite different now with many sporting valuations of only 12x-15x earnings and 15%-20% annual earnings growth.
Just because you get into a stock when its valuation seems reasonable doesn't mean you won't suffer a decline in share price after buying. Stocks that have fallen into my "reasonable" range oftentimes drop into "absurdly cheap" territory. Witness last fall's plunge. I picked up one stock with 20% earnings growth for less than five times 1999 earnings estimates. Within a month, though, it had fallen by more than half. Although I wasn't thrilled with my timing at that point, I still felt like the company was a splendid value. Fortunately, the stock has since quintupled. Such instant gratification only occurs rarely, but I'm not going to complain.
The most successful investors I've observed are those who are thoroughly patient. They patiently learn about a company to ensure that it has an excellent business model and strong growth prospects. They exhibit patience in waiting for the stock to achieve a reasonable valuation before purchasing. Finally, they demonstrate patience by holding onto their holdings through good and bad news, as well as the unavoidable ebb and flow of the company's stock price. Their reward is the superior rewards earned by great companies over long-time horizons.
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