Do you love bargains? Do you analyze almost all of your purchases to make sure you're paying a fair price? Many of us exhibit a strong preference for value when making purchases, especially big-ticket ones. Yet, when it comes to buying equities we often forget our value orientation and grab whatever sounds appealing at the moment.
Perhaps you have more discipline than most, but I know that this forgetfulness is real, because I have been guilty of it myself. About five years ago, I had a rather liberal investment strategy. I owned shares in Qwest (NYSE:Q) and Global Crossing (NASDAQ:GLBC) simply because companies and stock prices alike seemed to be growing quickly. At roughly the same time, I also scooped up shares in Warner-Lambert -- later acquired by Pfizer (NYSE:PFE) -- and Outback Steakhouse (NYSE:OSI), because I had performed a bit of analysis and I believed both were at least marginally undervalued.
Fast-forward a couple of years to the middle of the recent bear market. My portfolio, while not in tatters, was clearly separated into two camps. The first group contained investments that I had applied a value methodology to, and this group was holding up well. The other group was purchased with only a business evaluation and was mostly a mess, save for a few exceptions -- such as National Semiconductor (NYSE:NSM) -- that I can only describe as dumb luck.
It's probably not a surprise that at this point I became convinced that value investing has a few concrete advantages. I wasn't an expert at discounted cash flow analysis, but I learned to make a range of conservative estimates and committed myself to improving -- some excellent articles are linked at the bottom for those interested in following a similar path.
The cornerstone: margin of safety
Discounted cash flow analysis, balance sheet analysis, and other forms of analysis are not difficult to understand, but do take a great deal of time to truly master. Fortunately, you don't have to be an expert to get started and valuation is as much art as it is science. A good way to make up for the fact that we're not all Picassos is to calculate a range of values for a business based on a few scenarios and then assign a probability to each scenario. With the range of values for the business in hand, value investors focus on paying less than their estimate, giving them a margin of safety.
The concept of paying less than what you believe a business to be worth is what gives value investors a home-run punch. Some value hawks look for businesses selling at a discount of as high as 50%, or 50-cent dollars as fellow Fool Whitney Tilson likes to call them. In a slightly different twist, I vary the level of the discount between 30% and 50% depending on my assessment of business quality. With either philosophy, you'll miss out on a few moon shots because some companies never get cheap enough, but in exchange you'll miss more than your share of crash landings.
Absolute returns and capital preservation
While the primary reason to insist on a margin of safety may be to pay a fair price for a good business, there are the added benefits of capital preservation and absolute returns. Capital preservation may sound like a real snore, but when things don't play out as expected or the economy throws you a curve, you'll limit your losses.
Absolute returns are a bit more interesting. Here at The Motley Fool we often talk about market- or index-beating returns -- generally meaning beating the S&P 500. This is great when the index used for comparison has a positive return. But what about when the index is down 20%? Can we really declare victory if we only lost 16%? No one invests for negative returns, even if the returns are positive relative to a benchmark.
Of course value investing won't save you from losses. You'll lose some on the road to winning some (more, we hope); that's always been true. But it's the idea of explicitly seeking out a cushion that I'm trying to emphasize. In my example at the beginning, my investments in Outback and Warner-Lambert flourished in a bear market and kept me on track. I'd rather not rehash what happened with Qwest, Global Crossing, and other go-go equities during that time, but I'll readily admit that I took my beatings along with many others.
Avoid the garbage
Nothing makes a value investor's stomach turn more than investing in a company that looks cheap, but continues to disappoint. Like the used car whose price is just too good to pass up -- until you end up pouring in a few thousand bucks on maintenance and repairs. This is almost always due to a false assumption made up front. I haven't found a way to avoid these mistakes entirely, but I have found that making a list of assumptions about an investment going in and then following up on those assumptions will limit losses.
When a major assumption proves false and impacts my value of a business, I consider moving on to greener pastures. At times, businesses are tough to gauge and a stock price may stagnate even though the business is on track. I've held Costco (NASDAQ:COST) for a few years now, and while the business has continued to grow, the stock price barely moved until earlier this year. I couldn't tell you why the stock sat still, but by buying at a discount to my estimate of value and focusing on the business -- and not the stock price -- I held my shares, and it looks like I'll get the return I expected.
Wrap-up and an idea
Value investing won't yield a winner every time, but with the market up strongly since April 2003, I have been shifting to an even more stringent value focus. By no means am I forecasting market doom and gloom or advocating staying out of stocks entirely. But in today's market I find low-priced opportunities like Sanderson Farms (NASDAQ:SAFM) to be more interesting than stomach-churners like Travelzoo.
If you're interested in diving into value investing on your own, check out these articles:
- To get your hands dirty, try Discounted Cash Flow and Valuation With the Right Attitude
- Zeke Ashton's 10 Commandments of Value Investing
- Avoiding Value Traps by Whitney Tilson
Interested in value investing, but not interested in calculating a margin of safety? Give Motley Fool Inside Value a try for 30 days free!
Fool contributor Nathan Parmelee owns shares in Costco and Sanderson Farms. The Motley Fool has a disclosure policy.
