The Rewards of Valuation

If the most frequently asked question in investing is whether the market is going north or south, then this question is a close second: "Is [name your stock here] going higher?" It's a great question, but the answers can sometimes be entirely useless because they have very little regard for valuation.

Falling for the hype
I'm guilty of this from time to time. Consider a story I wrote about Oprah's "favorite things" for Christmas 2004. Though I included the typical disclaimer at the end of the piece, I was clearly head over heels for her proposed 2005 portfolio. Here's an excerpt:

But I love this show for the stock picks. No, Oprah doesn't actually give away analyst research or fling stock certificates into the stands. It's just that many of her favorite things are supplied by public companies, and some of her past selections would have made for great investments.

Fast-forward a year. Had you invested in the so-called Oprah portfolio, you'd be down 14% so far. Whoops.

Misery loves company
I'm not the only one who's fallen for the hype. Jim Cramer, host of CNBC's Mad Money, recently proclaimed that Deckers Outdoor (Nasdaq: DECK  ) would go higher because Oprah singled out the company's Ugg Uptown boots for this year's portfolio of favorite things. Allow me to quote from a recent show recap published by TheStreet.com (Nasdaq: TSCM  ) :

Most importantly, though, "Deckers has somebody better than Santa on its side. They've got Oprah!" said Cramer. Oprah recently featured Uggs on her TV show, "as one of her favorite things of 2005." Oprah is the reason the stock is up over the last month and will be the reason the stock is going higher, he said.

Cramer could be right, of course. And, in his defense, he's probably talking about the short term. Pricing stocks for the long term makes little sense when you're playing the momentum game. (And the stock is already up more than 22% since the boots appeared on Oprah's show.)

Everything worth buying has a price tag
But that doesn't change the fact that the biggest rewards come from buying to hold -- for decades, if possible. Take legendary investor Philip Fisher, for example. He bought up-and-coming radio manufacturer Motorola (NYSE: MOT  ) in 1955 and held it till his death last year. Hunt down the 50-year chart of Motorola's performance, and you'll see that this one investment worked out pretty well for Mr. Fisher.

Valuation has its rewards
Impressed? You should be. Fisher was one of the first growth investors, but he was highly conservative in his approach, as depicted in the less celebrated of his works, Conservative Investors Sleep Well. I've no doubt that Fisher had a price tag in mind before he bought Motorola. And he was justly rewarded.

So why, then, do we insist that Super Bowls, presidential elections, and Oprah have anything to do with individual stock prices? They don't. It's valuation that matters most.

Let's begin with Capital Automotive (Nasdaq: CARS  ) , a real estate investment trust (REIT) that Motley Fool Income Investor chief analyst Mathew Emmert picked for the October 2004 newsletter. Read what he had to say about the valuation of the company and its potential rewards:

Capital Automotive shares offer substantial value given the company's demonstrated ability to generate stable cash flows and its penchant for accretive acquisitions. Business fundamentals are improving across the board, yet the firm now changes hands at just 15.4 times forward earnings, a paltry 11.5 times my conservative FFO (funds from operations) estimate, and a mere 1.5 times book value. Given the quality of the company, these are very compelling metrics. My blended valuation model places Capital Automotive at $34 a stub. If the shares reach that price, investors will enjoy a 9.82% capital gain along with the solid 5.5% dividend yield.

Fast-forward one year. In September, Capital Automotive received a buyout offer for $38.75 per stub, a modest premium to Mathew's conservative estimate. Here's another example. In Mathew's "Cash Flow Corner" for the July issue of Income Investor, he singled out La Quinta (NYSE: LQI  ) for its exceedingly cheap price tag:

The shares are currently trading just above their book value of $8.25. Further, I calculate both the company's net asset value and its replacement value (i.e., the cost a company would incur to build or acquire a similar portfolio of properties) at $11 per share, and my discounted cash flow model pegs the stock at $12. That would produce a 41% capital gain.

The Blackstone Group, a New York-based private equity firm, noticed. Its buyout offer of $11.25 was accepted three weeks ago. Anyone who followed Mathew's thesis stands to pocket a capital gain of more than 24% in less than six months. Nice.

Get paid to wait for your price
Mathew's approach is to buy stocks paying sizable dividends for less than their estimated intrinsic value. Or, as I like to call it, getting paid to wait for your sell price. It's a strategy that has paid off in more than just the two instances I've mentioned above, which is probably why the portfolio has beaten the market since it began in the summer of 2003.

Yesterday, Mathew issued a fresh update on developments in the portfolio. Try out a risk-free 30-day trial and the update, as well as all of Mathew's buy reports and "Cash Flow Corner" missives, is yours. Or sign up for a year and Mathew will send you Stocks 2006, which features our analysts' best picks for the year ahead, gratis. And everything is backed by our no-questions-asked money-back guarantee. How's that for a price tag?

Fool contributor Tim Beyers reads the price tag closely before buying pretty much anything. He suggests you do the same. Tim didn't own stock in any of the companies mentioned in this story at the time of publication. You can find out what is in his portfolio by checking Tim's Fool profile. Deckers Outdoor is a Motley Fool Hidden Gems recommendation. The Motley Fool has an ironclad disclosure policy.


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