FOOL ON THE HILL
10 Gems for Value Investors

Like other so many other great money managers, Bob Olstein is not only a great investor but a great teacher of investing as well. Here we examine 10 of Olstein's market-beating investment principles.

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By Matt Richey (TMF Matt)
April 30, 2002

Investing legends Philip Fisher, Warren Buffett, and Peter Lynch were remarkable in that they were great investors and great teachers. Today, I'd like to introduce you to a lesser-known but highly successful money manager, Bob Olstein, whose writings are also a treasure trove for students of investing.

Bob Olstein, manager of the Olstein Financial Alert Fund, has run circles around the S&P 500 over the past five years, earning 23% annually for his investors versus 7.5% for the index. Olstein's winning approach to investing is articulated on his website through many excellent articles, one of which ("We Are Concerned About Our Performance") reduces his value investing philosophy to 30 short principles. Today, I want to share with you 10 of my favorite Olstein principles, along with a few thoughts of my own on each one.

1. Buying companies with excess cash flow (more cash coming in than going out) is the best defensive maneuver against financial risk.

A contrast of Cisco (Nasdaq: CSCO) and Lucent (NYSE: LU) provides a perfect example of this principle. Cisco's consistent cash generation, even through the recent downturn, has prevented its shareholders from suffering the degree of losses faced by Lucent holders. All along, the difference in risk between the two companies should have been readily apparent to anyone paying attention -- Lucent has been bleeding cash from operations since 1999, whereas Cisco has generated operating cash flow profits for every fiscal year going back to 1995. While neither company has been a good investment over the past several years, a comparison of stock performance over just the past 52 weeks finds that Lucent shareholders have lost an additional 50% of their investment, whereas Cisco holders are sitting at about breakeven.

2. Volatility does not represent risk but creates opportunity.

This notion causes most finance academics to foam at the mouth, but volatility is the friend of the value investor. Every stock has a great deal more volatility than does the underlying business. For example, I found that the average S&P 500 stock over the past year ranged nearly 30% from its midpoint price to its 52-week high or low. Detailed knowledge of a company can allow you to take advantage of this volatility. The key is being able to assess a stock's approximate fair value. With that knowledge in hand, a stock's volatility over the course of time will likely present an opportunity for you to acquire shares at a price below your fair value estimate.

3. Risk is defined by financial strength, predictability of cash flow, and quality of earnings; as opposed to the size of company, number of years in business, and the volatility of the stock.

This is a fantastic definition of what risk is and what it is not. Big, old companies are not necessarily conservative investments. AT&T (NYSE: T) and Ford (NYSE: T) investors over the past year can attest to that fact. It's the Olstein perspective on risk that makes me a very comfortable owner of tiny Integrity Inc. (Nasdaq: ITGR). The company has only $71 million in sales and a market cap approximately half of that, but I consider the risk to be low given its reliable cash generation and pile of cash in the bank.

4. We would rather spend one night with a company's financial statement looking behind the numbers via an inferential analysis, rather than one day with management. Management is not the answer to error avoidance and defensive investing.

Unlike managers, the numbers rarely lie. Name practically any company that's fallen from glory over the past year because of financial disaster -- Enron, WorldCom (Nasdaq: WCOM), Gap (NYSE: GPS), VeriSign (Nasdaq: VRSN) -- and you have an example of a company that you'd have been better off studying the financials than talking to management.

5. Waiting for the catalyst to appear before buying an undervalued stock will result in the purchase of a fully valued stock.

I like this one a lot because I believe sheer value to be a perfectly sufficient catalyst in and of itself. Remember Abercrombie & Fitch (NYSE: ANF) at $10 a few years ago? There weren't any catalysts in sight back then, but the stock traded for a P/E of under 8. Today, the stock is at around $31, selling for about 19 times earnings.

6. The timing in value investing comes from paying the right price. Unfortunately, the right price usually occurs in conjunction with negative business fundamentals and/or periods of negative psychology.

A good example is Southwest Airlines (NYSE: LUV) during the week after the events of 9/11. Amidst a huge swell of negative psychology, a short-lived opportunity arose to buy the premier airline for $12, or around 15 times trailing earnings. The stock has since recovered to its pre-9/11 levels above $18. As Warren Buffett has said, "A great investment opportunity occurs when a marvelous business encounters a one-time huge but solvable problem."

7. The most important virtue of a value investor is patience. Periods of misperception usually take longer periods of time to unwind, but the rewards for patience can produce the returns you seek.

For beaten-down, hated stocks, patience is a must. An example from my own portfolio is Elan Pharmaceuticals (NYSE: ELN), which I bought after it tanked on accounting concerns this year. I bought knowing that the stock had little chance of recovering anytime soon, but with a single-digit P/E ratio, enough cash to cover its off-balance sheet debts, and a legitimate pipeline of several promising drugs, I liked and continue to like my chances of an eventual turnaround in the stock price. I'm willing to wait the likely 12-24 months necessary to get the payoff I'm expecting.

8. You cannot limit your search for value. Value can occur in large companies, small companies, cyclical companies, growth companies, technology companies, etc. Setting up artificial barriers to investing can be performance limiting.

William Miller of Legg Mason Value Trust has used the same broad concept of value to beat the S&P 500 for the past decade. In the mid-90s, Miller was brilliant to buy Dell (Nasdaq: DELL) and AOL (NYSE: AOL) at seemingly high multiples to current earnings given the earnings boom that both companies were about to enter into. Value investing doesn't mean buying a certain type of company; it just means buying companies that are undervalued based on a rational, conservative analysis of the fundamentals.

9. Having a strict sell discipline based on cash flow valuations rather than the price momentum of a stock is difficult to practice, but it is a required discipline of a value investor.

When to sell is the most difficult question an investor faces. As a value investor, though, the answer is clear (if not still difficult in practice): Sell when a company reaches your estimate of full valuation. In my own portfolio, I've begun to sell a retailer that has shot up 100% from my purchase price a little over a month ago and recently surpassed the low-end of my estimate for fair value. It has been difficult to sell given the awesome momentum, but this is the discipline necessary to keep my portfolio positioned in companies that all have rationally determined valuation upside.

10. Never allow tax decisions to take precedence over investment decisions. Any overvalued stock should be sold regardless of tax consequences. We hope your biggest investment problem is high taxes produced by high profits.

I think tax consequences were one of the main reasons investors hung on to overvalued stocks during the mania. The desire to avoid taxes is so strong that it occasionally warps good investment decision-making. This principle is related to #9: Nothing should stand in the way of selling your fully valued stocks -- not stock price momentum, not taxes, not a "moral" commitment to long-term investing. When a stock reaches full valuation, it's time to sell.

These are just 10 of Bob Olstein's investing principles. For his 20 other value investing tenets along with numerous interesting articles, I encourage you to visit the "In the Manager's Opinion" section of Olstein's website.

Matt Richey is a senior investment analyst for The Motley Fool. At the time of publication, he was long on Integrity Inc. and Elan Pharmaceuticals and had no position in any of the other stocks mentioned. Matt's personal portfolio is available for view in his profile. The Motley Fool is investors writing for investors.