FOOL ON THE HILL
Thoughts on Value Investing

Why will investors wait for a better deal on a car, but not a stock? Whitney Tilson discusses the elusive but vital topic of value investing in his first Fool on the Hill column, trying to hammer down not only what it is -- but what it isn't.

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By Whitney Tilson
November 7, 2000

With the suspension of the Boring Portfolio, I'll now be writing in this space every Tuesday. Since many Fools may not have spent much time in the backwaters of the Bore Port, I'd like to use this, my first Fool on the Hill, to introduce myself. (I don't have much space here, so I've included links to many of my favorite articles below; links to all 45 Motley Fool columns I've written over the past year are on my website.)

Unlike pretty much every other writer for the Fool, I don't work for the Fool. I'm a money manager in New York City, though I'm about as far from the fast trading, Wall Street stereotype as you can get. I've been a consultant and entrepreneur (many times over), and have an MBA, but have never worked for a financial firm. In fact, not too long ago I was an individual investor just like you. I taught myself how to invest by reading voraciously, then began to manage my own money, then some for my family, and eventually started my own firm.

What is value investing?
I am a value investor, though if you looked at my portfolio, you might scratch your head and wonder. I'd like to use the rest of this column and the next one to share my thoughts on value investing, especially as it applies to the New Economy.

Very simply, value investing means attempting to buy a stock (or other financial asset) for less than it's worth. In this case, "worth" is not what you hope someone else might pay for your stock tomorrow or next week or next month -- that's "greater fool investing." Instead, as I wrote in Valuation Matters, "the value of a company (and therefore a fractional ownership stake in that company, which is, of course, a share of its stock) is worth no more and no less than the future cash that can be taken out of the business, discounted back to the present."

Buying something for less than it's worth: What a simple and obvious concept. Charlie Munger said it best at this year's Berkshire Hathaway annual meeting: "All intelligent investing is value investing." Bargain hunting is pretty much what everyone tries to do when buying anything, right? How many people walk into an auto dealership and say, "I want to buy your most popular car, and I don't care about the price. In fact, if the price has doubled recently, I want it even more."? Conversely, why would someone be deterred from buying if the dealer had recently marked down the price by 25%? And how many people would buy a car based on a stranger's recommendation, without doing any of their own research?

So why do so many people behave like this when buying stocks? The answer lies in part, I suppose, in the realm of human psychology -- the assumption that the crowd is always right, and the comfort of being part of the herd. Also, there's the thrill of gambling and the hope of a big score. (I intend to return to the topic of behavioral economics -- the subject of my first Motley Fool column, The Perils of Investor Overconfidence -- in future columns.) Another factor is that valuation is tricky -- it's hard to develop scenarios and probabilities to estimate a company's future cash flows. But that's no excuse. As I argued in perhaps my most controversial column, The Arrogance of Stock Picking, if you don't have the three T's -- time, training and temperament -- that are the basic requirements for successful stock picking, then you're very likely to be better off in mutual funds (or, better yet, index funds).

As I noted in my follow-up column, More on The Arrogance of Stock Picking, "I think it's a sign of the times that this [point of view] would be considered by some to be controversial or insightful. Heck, I'd give you the same advice were you to undertake any challenging endeavor: piloting a plane, teaching a class, starting a business, building a house, whatever. But when it comes to investing, people are bombarded with messages that they should jump into the market and buy stocks, and of course there is no mention of the risks involved or the skills required to invest properly."

I think my arguments largely fell on deaf ears during the madness earlier this year. With the unfortunate pain many unsuspecting investors have experienced since then, maybe now there will be a more receptive audience.

What value investing is NOT
Many people think that value investing means buying crummy companies at single-digit P/E ratios. Ha! While some value-oriented investment managers have fallen into this trap (the subject of my column, Should Warren Buffett Call It Quits?, which compared Warren Buffett with the Tiger Funds' Julian Robertson), I'm skeptical that there's much genuine value in companies trading at low multiples but with poor financials and weak future prospects. Buffett agrees. In his latest annual letter, he wrote: "If the choice is between a questionable business at a comfortable price or a comfortable business at a questionable price, we much prefer the latter. What really gets our attention, however, is a comfortable business at a comfortable price."

Nor does value investing rule out taking risks. If the potential payoff is high enough, even the risk of total loss is acceptable. For example, every value investor I know of would jump at the chance to invest at least a small portion of their assets in a coin toss, where heads would pay 5x, but tails would yield a total loss. (I make similar calculations when I make venture capital investments.) Unfortunately, however, as I argued last month in Perils and Prospects in Tech, many people take tremendous risks -- often unknowingly -- by buying high-flying stocks in the belief that they are making such a bet, when in fact the odds are far worse.

This does not mean that value investing excludes all companies with high P/E ratios (though I would argue, as I did in Cisco's Formidable Challenge, that very few businesses of any size are likely to be undervalued if they trade above 50x earnings and certainly 100x). For example, I bought Intel early last year at approximately 25x trailing earnings. That may not sound like a bargain, but I felt that this exceptional company would generate enough cash over time to justify its price. Despite its recent hiccups, my opinion hasn't changed and I'm still holding.

As this example shows, I don't believe that value investing precludes buying the stocks of technology companies. While Buffett is famous for his aversion to such stocks (the subject of my column, Why Won't Buffett Invest in Tech Stocks?), he does not deny that there can be wonderful bargains in this arena. He simply says:

"I don't want to play in a game where the other guy has an advantage. I could spend all my time thinking about technology for the next year and still not be the 100th, 1,000th, or even the 10,000th smartest guy in the country in analyzing those businesses. In effect, that's a 7- or 8-foot bar that I can't clear. There are people who can, but I can't. Different people understand different businesses. The important thing is to know which ones you do understand and when you're operating within your circle of competence." (1998 annual meeting)

I urge you to think about your circle of competence. Understanding it -- and not straying beyond it -- is one of the most critical elements of successful investing. Another critical element is a firm grasp of Sustainable Competitive Advantage.

Conclusion
Value investing is very simple in concept, but very difficult in practice. The market, for all its foibles, tends to be quite efficient most of the time, so finding significantly undervalued stocks isn't easy. But this approach, done properly, offers the best chance for substantial long-term gains in varied markets, while protecting against meaningful, permanent losses.

Next week I will continue with some thoughts about why, despite being a value investor, I embrace rather than shun the tech sector.

-- Whitney Tilson

Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for the Motley Fool and other writings, click here.