Hi, everybody. I'm Jim. I used to think value investing was dumb.
("Hi, Jim," I hear from everybody.)
It all started in 1999, when I began investing amid the furor of the dot-com bubble. I had decided to buy shares of Outback Steakhouse, which had declined from $30 per share to around $25. Outback was a growing and popular restaurant chain at the time.
I threw my whole wad of grad-student cash ($3,000) into the transaction -- my first ever -- on the now-defunct Suretrade. I watched and waited for a quick return to $30.
The market climbed and climbed. Stocks from Web companies with the flimsiest of business models just kept soaring. Price to earnings? How about price to eyeballs? eToys' losses be damned! But even tech stocks with decent models hit the ceiling whenever an analyst raised a price target.
And meanwhile my real, live bricks-and-mortar business -- fully profitable and growing, mind you -- continued to fall.
Yes, friends, I soon succumbed to the siren song of quick bucks and filthy lucre promised by momentum investing (without really finding either for very long). But it seems to work great for some, so I want to highlight three rationales for momentum investing.
1. Why should I wait to be wealthy?
Indeed, why? All else equal, I'd rather have a 10-bagger next week than at some indeterminate time in the future. And with momentum investing, the upside volatility -- the type of volatility no one complains about -- can be immense and quick.
Longtime investors in Netflix (Nasdaq: NFLX ) should congratulate themselves. They've seen shares skyrocket more than 1,200% since late 2004. And among that group of happy investors is Motley Fool co-founder David Gardner, who picked the media company then for Stock Advisor subscribers. To be fair, David didn't select the stock as a momentum play, but rather because he saw the vast opportunity sprawling before Netflix.
The company still has tremendously bright prospects, and its subscriber base is growing faster than a weed on Miracle-Gro. After a huge run-up, Netflix now sits among the top 20 on the IBD 100, Investors Business Daily's weekly list of the hottest stocks. And so it's become a darling for momentum investors, who have pushed the shares up to 67 times trailing earnings. At that rate, every dollar in earnings turns into $67 in shareholders' pockets.
Some investors love this type of momentum play: the rising multiples backed by strong earnings and a seemingly limitless future. Baidu (Nasdaq: BIDU ) has seen earnings grow by 74% annually over the past three years and now sports a 93 P/E. Its dominant position in the Chinese portal market is drool-worthy.
You've seen a similar performance out of other momentum darlings, such as Chipotle (NYSE: CMG ) and Apple, whose business franchises continue to rock the world. Chipotle is now developing a new restaurant concept and going international.
2. No long-term exposure to the market (especially good if the market declines)
Many momentum investors like the fact that they're in and out of the market repeatedly, picking their spots for quick gains and then going on the lookout for more perfect setups. And if you're consistently able to choose profitable scenarios and not married to your positions, then you're able to move up when the market does and stay out when it's falling. Why hang on to Baidu or Netflix in late 2008 and endure weeks of declines?
3. Momentum stocks are more exciting
No question about this one. Momentum stocks are more exciting. Tell someone you invested in Ditchdiggers Inc. at a bargain basement price of five times earnings and watch the yawns flutter out. Value investing is boring. On the other hand, you can regale others with your purchase of the hottest gadget maker of the past decade -- Apple -- and you're the envy of the neighborhood. And even Apple at 20 times earnings, a cash hoard of tens of billions, and some interesting growth prospects could be a value investment, albeit not a traditional one.
A pitch for value investing
But do the stocks already reflect that great performance? Each of these four companies mentioned -- Netflix, Baidu, Chipotle, and Apple -- numbers among the top 20 stocks on the IBD 100. Following the highfliers will never be a system that works for me. You know what happens to stocks once they drop off the IBD list? They crash. Hard. Especially the top stock. But, you say, you can get out before they fall. How do you know beforehand that a temporary price decline won't become a full-fledged swoon? That's exactly the problem: Momentum investing has no true exit strategy. Why should a P/E of 67 or 93 be the correct valuation? Investors may bid the valuation higher, but they might finally decide not to.
The appeal of the "next big thing" certainly must have been attractive to long-term holders of Sirius XM Radio (Nasdaq: SIRI ) , who endured years of operational losses that led to massive stock declines. But the company became a great value candidate in early 2009, after being bailed out by opportunistic investors, and now it's sitting on four straight quarters of profitability. And it's up more than 20 times in value since then.
I need to know that a stock is cheap with a good degree of certainty (so that I can buy more if it declines), and a value-based methodology provides that discipline. Add in the bonus that a lot of value stocks pay dividends, and you're looking at a potential market-beating proposition with a higher certainty of gain. Here are a few value stocks, some of which I own.
Take mortgage REIT Annaly Capital (NYSE: NLY ) , which makes money on the interest rate spread and has paid out a 15% dividend over the past year. With the bond markets pricing in almost no inflation for the next five years and then only moderate inflation for another five, the macroeconomic conditions seem to be in favor of this payout continuing for some time. It trades at a price-to-book ratio of 1.2.
Another high-yield value is Frontier Communications (NYSE: FTR ) , which sports a payout of 8.2%. After recently acquiring operations from Verizon, Frontier is going about consolidating the business, and the market seemed to like its most recent earnings report. In the report, the company projected even more synergies from the deal than originally estimated.
Altria (NYSE: MO ) is also on the list, trading at 14 times earnings. The company has committed to pay out 80% of its income as dividends and has one of the best-known brands in Marlboro. Competition is limited by heavy regulation, and the high return of cash to shareholders is a huge positive.
I'd also add two companies that have dominant positions in their industries: McDonald's and Microsoft. The first has a cache of hidden assets, while Microsoft has a stranglehold on a few of its markets and trades at just 12 times earnings. Both are committed to paying increasingly large dividends, as I detail in the above links.
Foolish takeaway
And what if I had held onto my shares of Outback instead of selling them to buy the popular stocks of the day? Well, in four years Outback had nearly doubled my buy-in price -- but I was no longer in it -- and then it finally got bought out in early 2007. A double coming out of the dot-com bust? Really.
I chased the Johnny-come-lately highfliers. And then I crashed. But I'm now recovering. Every day I'm recovering. And I'm on the value-investing wagon; I buy only cheap. What about you?
If you like potential high-flying momentum-style plays, then click here for a free copy of our special report: The Top 2 Plays for the Coming Tech Boom. These two leaders should skyrocket as this entertainment niche grows into a $91 billion market by 2015.
If you're more of the value persuasion like Warren Buffett, then click here for a free copy of our special report that details one health-care company the Oracle of Omaha is quietly buying.
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