To me, "value investing" is a repetitive term. What is investing, if not the search for businesses offering value? Still, many investors miss the point of value investing entirely -- because they fail to spot the one factor that defines every great investment.
Common misconceptions
Not all value stocks boast low price-to-earnings (P/E) multiples. And companies with low P/E ratios are not necessarily value stocks. It's true that in the long run, the odds suggest that companies sporting lower earnings multiples should perform better over time. But simply buying a company selling at less than 10 times earnings is not value investing.
What makes a company today worth much more tomorrow is the presence of a catalyst -- an event that unlocks value. The list of potential catalysts can be exhaustive, so let's stick to three examples that are easier to spot than others.
New management
When all else fails, a troubled company usually must replace current management, and a fresh hire can sometimes unlock value. Under CEO Carly Fiorina's watch, Hewlett-Packard (NYSE: HPQ) suffered setbacks that, regardless of the source, fell upon the boss's shoulders. After Fiorina's dismissal in early 2005, Mark Hurd stepped in as the new CEO and chairman, helping to boost shares from $20 at his March 2005 arrival to today's $50 range.
Amid the current credit turmoil, the CEOs of Merrill Lynch (NYSE: MER) and Citigroup (NYSE: C) both recently resigned. Citigroup continues its search for a new chief, but Merrill has tapped John Thain, CEO of NYSE Euronext (NYSE: NYX). Thain won kudos for reviving the Big Board and successfully merging it with the Euronext. He also offers some much-needed experience in risk management, since he worked at the mortgage-bond desk of Goldman Sachs, the only Wall Street firm to emerge from this credit mess smelling like roses. With a new catalyst, Merrill, which once traded at nearly $100 a share, could offer an intriguing opportunity once the fog clears up.
New markets
In the late '80s, the video-rental business was just getting started. At that time, most video rental operations were locally owned dives, and Wayne Huizenga was running a small video chain by the name of Blockbuster. Convinced that the video rental market was in its infancy, he embarked on a breathtaking expansion of Blockbuster stores. By 1994, when Huizenga sold the company for $8.4 billion, Blockbuster had more than 3,700 stores. From an idea to more than $8 billion in less than a decade? Now that's a new market! (This amazing story can be found in The Making of a Blockbuster by Gail DeGeorge, an inspiring account of Blockbuster's success under Huizenga.)
Improved fundamentals
Recently, Warren Buffett disclosed a sizable stake in railroad operator Burlington Northern Sante Fe (NYSE: BNI). Generally, railroad companies are capital-intensive, operate with razor-thin margins, and carry heavy leverage - qualities that Buffett systematically avoids. So what gives?
Apparently, Buffett feels that for the first time in a long time, the railroad industry's fundamentals are improving. Thanks to the commodity boom in China and India, railroads are operating at full capacity. In addition, technological innovations like double-stacked railcars provide greater efficiency per mile. In short, railroads are beginning to generate returns above their cost of capital. Given Buffett's long-term view, Berkshire Hathaway's (NYSE: BRK-A) (NYSE: BRK-B) large stake in Burlington suggests a positive shift in the railroad industry.
Value or value trap?
The creation of value defines a successful investment. That value can come in many shapes and sizes, but a good investment will always unlock it. Identifying catalysts like the three above will help you determine which companies are likely to unlock their value, and which will remain locked down.
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