Investing Where the Monkeys Whiz

I suppose I'd better start by explaining that headline.

I recently got back from a holiday trip to one of my favorite places in the world, the Netherlands. In the beautiful city of Haarlem -- where pedestrians and bicycles rule and cars get out of the way -- there's a museum dedicated to the city's most famous painter, Frans Hals. But as amazing as Hals' works are, there was another picture in that collection that stuck with me much longer.

It's a satire of the tulip craze painted by Jan Bruegel the Younger. (You can search for it via the museum's website.) The late 1630s craze is an oft-evoked investing metaphor. In a nutshell, tulip bulb prices inflated to incredible heights, reaching sums equivalent to a house on the best canal in Amsterdam. Anyone and everyone got in on the trade, and no one bothered to wonder what a tulip bulb was really worth because there was always some sucker who'd buy yours for an even more outlandish price. Until there wasn't.

Bruegel's opinion of anyone involved in the trade could not be clearer. Monkeys play the part of the country's well-dressed business class. They bid on tulips, examine tulips, read about tulips, talk about tulips, fight over tulips, waste their fleeting tulip gains on expensive food and booze, cry over lost tulip fortunes, and, in one corner, one little monkey sums up the painter's opinion of the entire craze.

All alone, the only monkey with the guts to admit the truth whizzes on a pile of tulips. The moral of the story: Don't invest where the monkeys whiz.

No craziness in value
That's a philosophy that stock cheapskates like those of us at Inside Value take seriously. And it's an important concept to keep in mind, because as ludicrous as it sounds, even the most disciplined among us sometimes get an irresistible urge to invest where the monkeys whiz.

In that respect, we're a lot like the 17th century Dutch. Remember, these people were not idiots, especially where financial matters were concerned. In fact, they rank among the greatest businessmen in the history of the world. The country's best-known enterprise, the Dutch East India Company, was successful and ruthless enough to become a threat to entire nations, including superpowers England and Spain.

So, how did this incredibly sophisticated commercial society get caught up in such a frenzy? By ignoring some simple, time-proven rules on purchasing investments. What's the real value of this thing I'm buying? Am I sure? How much should I pay?

These are the same questions investors must face every time they click that buy button. Unsure whether you're investing at the wrong end of the monkey? Here are a few ways to find out.

If you think a $10 share is less expensive than a $20 share, you're almost certainly investing where the monkeys whiz.
This is a pretty basic valuation concept, but it's a question I continue to get via email. Simply put, a company's current value, as measured by market cap, is not just a function of its share price. It's a multiple of the share price times the number of shares outstanding. If my Furby-repair company sells for $1,000 per share but there are only 1,000 shares, it's worth a million bucks on the market. Home Depot's (NYSE: HD  ) shares only fetch $41 a stub today, but since there are lots of them, the market cap for the company stands at $90 billion. (If you need a brush-up on your basic stock skills, head on over to the Fool's School, and welcome.)

If you're unaware of the potential difference between a firm's present street value and its real "intrinsic" value, you might be investing where the monkeys whiz.
Unfortunately, the value of a company is not well represented by its market cap. Its underlying worth to you as an investor is a concept sometimes referred to as its "intrinsic value." This is what we believe the company to be actually worth, based on expectations of revenues, earnings, and other factors. At any time, a company may be trading for more or less than what investors consider its true intrinsic value. As value investors, our goal is to find companies that sell for less -- a lot less -- than the figures we consider to be their true or intrinsic values.

For example, after Colgate-Palmolive (NYSE: CL  ) posted some numbers that disappointed most of Wall Street last fall, it took quite a beating. But given the strength of its brands, its cash flows, and its willingness to make tough decisions to benefit shareholders, I figured it was a good buy in the middle and low $40s. By some very simple comparisons, I figured it was worth at least $55 or $60. Coincidentally, our own value guru Philip Durell came to the same conclusion (we never actually discussed it) and he recommended it for the newsletter in December. It's up nearly 13% since then.

If you trust mass media's earnings headlines and company PR, you might be investing where the monkeys whiz.
As we've said here many times before, earnings are an accounting opinion, and they're open to major manipulations, all of it perfectly legal. The earnings-release problem is exacerbated by the fact that the news drones at the AP, Reuters, wherever, rarely do anything more than regurgitate the press releases that come from the companies themselves. Sound like the kind of scam run by one those shady upstart tech firms? Think again. Even stodgy old Ford (NYSE: F  ) used some interesting bean-counting tricks to puff up earnings this year.

Unfortunately, to find the truth, you need to dig into the financials yourself. Even an Art History major can do this, folks. A quick check of Ford's financial results a couple of months back confirmed my suspicion that it was booking unsustainable profits from its financing unit by simply reducing the write-offs necessary to ensure against bad accounts. Now, people seemed surprised (not me, though) that Ford announced that its financing unit would not continue to outperform. The bottom line: You need to read the sheets to make sure your portfolio is free of monkey whiz. (If you're new to reading corporate financials, there are plenty of savvy, friendly skinflints on the Inside Value discussion boards to help you hone your skills.)

If you buy stocks whenever the headlines on the business section look positive, and sell when they get gloomy, you're definitely investing where the monkeys whiz.
I've said this time and time again on the Fool. Most of the time, the press has it dead wrong. Writers and editors need headlines and they need to look like they know what's going on. In truth, they have no idea whatsoever. Better yet, the big picture says nothing about your individual stocks. By finding undervalued companies and holding them until the Street appreciates what you saw long ago, you avoid the sickening horse race that is the financial media's daily market updates.

If you buy a stock based solely on your love for the product, you might be investing where the monkeys whiz.
Betamax? Satellite telephone? Pet rock? Boston Chicken? KrispyKreme (NYSE: KKD  ) ? Do I need to say more? A product, no matter how great, is not an investment case. The bottom line for you as a shareholder is "what do I stand to gain?" It doesn't matter how much product a company can move if there's no trickle-down for shareholders. Unfortunately, many people are so addled by their love of the goods that they don't do the math. There were some people worried about the numbers at Krispy Kreme long before the average, donut-blinded stock speculator saw the harsh truth. Investors lost millions as a result.

If you haven't planned for the likelihood that your evaluation of a company could be wrong, you might be investing where the monkeys whiz.
In value investing, we call this preparation the margin of safety. It's not enough to do careful math and be convinced that the company you're buying will be worth more down the road than it is now. When we're making a value investment, we assume that we're going to be wrong some, if not much, of the time. How do we cope? We look for firms that are so cheap that there's little downside even when we are wrong. Contrast this to the valuation strategy of people on the opposite end of the investing spectrum: Growthies will pay just about anything for that hot new commodity. "The fundamentals will catch up," they say.

Maybe. Usually not. The danger to you is when that hot new commodity doesn't live up to expectations -- even if it does continue to grow at a huge rate. Bang! You are looking at major market spanking. Auction powerhouse eBay (Nasdaq: EBAY  ) is a great company, but its recent fall is a direct result of a fundamental reassessment of its expected growth, previously thought to be infinite.

If you buy stocks based on peer pressure, you're definitely investing where the monkeys whiz.
For some reason, the Wise on Wall Street insist on telling us that the best time to buy stocks is when they're heading up. Ridiculous. The toughest thing about value investing is that success means ignoring the popular kids and hanging out with the geeks. Huge potential profits await those of us who are clever enough -- and brave enough -- to buy what everyone hates. Not long ago, I told the story of how last year's horror story at Nokia (NYSE: NOK  ) provided me with a quick 40% gain. I've used similar tactics to get into companies that don't fit the usual definition of a "value." Chico's FAS (NYSE: CHS  ) is one of them. Value can appear anywhere, even at a store designed for glittery little girls.

Of course, buying at the bottom is never easy. If it were, everyone would be doing it and, well, there wouldn't be any bargains out there. Personally, I think you can gather the guts to make these calls and stop investing where the monkeys whiz. But if you'd like a dose of courage (not to mention guidance), you can take a trial of Inside Value, on the house. Unlike those pricey growth stocks out there, this offer's risk-free.

For related Foolishness:

Seth Jayson shops the bargain aisles in every endeavor. At the time of publication, he had shares of Chico's FAS and call options for Nokia. View his stock holdings and Fool profile here. Fool rules are here.


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