The Danger in Catching Falling Knives

By a lot of measures, today's markets look cheap.

Stocks are down nearly 15% since October, the S&P is trading at a forward price-to-earnings ratio of 13.2, and hundreds of solid businesses are trading at multi-year lows.

Single-digit price-to-earnings ratios are widely available for the taking. Still, I would caution against mistaking low prices and low "valuations" for true value.

If it's too good to be true...
"Don’t catch a falling knife." We’ve all heard this expression before, right? More often than not, a cheap stock reflects the underlying quality of a business’s assets, meaning it’s not a bargain investment. If a falling stock price is accompanied by a decline in intrinsic value, then the underlying shares in the business are not undervalued. At best, they are fairly valued, meaning the decline in market value is commensurate with loss in intrinsic value. At worst, they are still overvalued, meaning Mr. Market has not fully digested the extent of the deteriorating value of the business. These "falling knives" can be dangerous if you catch them the wrong way.

A look into intrinsic value
Most investors swagger when trying to figure out intrinsic value. The belief is that at any given moment, intrinsic value is one fixed value. Actually, determining intrinsic value is more art than science. Intrinsic value can be influenced in many ways. The most fundamental and concrete look into intrinsic value focuses on the cash generated by a business. Cash is real and can be used to expand the business, buy back stock, and pay dividends. The idea here is to estimate the future cash that will be generated, discount it back to the present, and compare that present value with the current market value. To see this process in action, take a look at this one attempt to valueGoogle (Nasdaq: GOOG  ) .

Another approach to determining the intrinsic value of a business requires a bit more skill that develops over time. This approach looks into buying good growth businesses at a good price. (Think of Warren Buffett, who said, "Better to buy a great business at a fair price than a fair business at a great price.”)

A great example was revealed in the 2007 Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) annual report. Any nuggets of wisdom regarding valuing a business provided by Buffett should be taken as gospel. In the letter, Buffett discussed his investment in Chinese oil company PetroChina (NYSE: PTR  ) :

“In 2002 and 2003 Berkshire bought 1.3% of PetroChina for $488 million, a price that valued the entire business at $37 billion. Charlie [Munger] and I then felt that the entire business was worth $100 billion.”

Clearly, Buffett did not just magically dream up the $100 billion number. Buffett was obviously very familiar with the oil industry and its fundamentals. He compared the value of PetroChina and the company's oil reserves with that of similar large oil enterprises and concluded that at the current price of $37 billion, the company was below intrinsic value going forward. These types of investment opportunities -- finding value in growth -- can lead to very profitable opportunities.

Price the stock
What Buffett saw in PetroChina is what you want to see happen with intrinsic value over time. In order to achieve this result, you have to look at the business, the industry, and the competition. A company that is continually profitable will always attract competition from invaders, so you have to determine how the business can continue to create value under the threat of that competition. We all like big moats and we cannot lie. If the picture still looks bright, then you are on to something.

Instead of looking at stock prices, focus instead on pricing the stock. For instance, the current prices of Ambac (NYSE: ABK  ) and MBIA (NYSE: MBI  ) appear to indicate attractive opportunities for these bond insurers once the credit markets stabilize. This may indeed be true, but I doubt that the credit environment going forward, which is certain to be much more scrutinized and regulated, will allow these companies to generate the same levels of profitability as before. If this is indeed the case, then you must realize that in the future, intrinsic value might not return to its former levels.

The same scenario applies to financial stocks. Nearly all of them are currently trading at multi-year lows, but one important source of profits -- credit derivatives -- will surely deteriorate when the current turmoil finally ends. You probably want to avoid companies that were overly reliant on this line of work.

Avoid the pitfalls
A low stock price can be dangerous if it’s accompanied by declining business fundamentals. Look carefully into the business before fixating on the stock price. Ask yourself one important question: "What will this business look like in the next five years?" With a company like Coca-Cola (NYSE: KO  ) or Wal-Mart (NYSE: WMT  ) , the answer is reassuring. Yet for others, like the bond insurers, some homebuilders, and mortgage outfits, the picture is not clear. Avoid driving with a foggy mirror, and you're more likely to avoid the pitfalls.

For more very reasonably priced Foolishness:

 


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