There's a street in New York City where well-dressed men and women go to give away money every weekday. Cries go out, similar to "Hey, buddy, I'll give you three tens for that twenty" or "Can you break a fifty? Give me two twenties, and we'll call it even." These are people with college or even graduate-level educations, and they're making bad deals on a very regular basis.
The place is Wall Street, and the venue is the stock market. That's where these folks meet every day to throw away their money. There is a tendency to overreact on Wall Street. To the folks there, when news is good, it is very, very good, and when news is bad, it's horrendous. And when bad news hits a company, market participants are often willing to say, "Give me two twenties, and I'll give you this fifty," and sell companies at substantial discounts to their intrinsic worth. This is the kind of deal Philip Durell scouts out for his Motley Fool Inside Value newsletter service.
For an investor with the right qualities, being on the right side of such deals can be quite profitable. It takes three primary characteristics to take advantage of such opportunities:
- Objectivity.
- Confidence.
- Patience.
With those qualities firmly in place, value investors can profit from the market's mispricing.
Seeing what others can't
First, a value investor must be objective when determining the true value of a business. As Benjamin Graham taught, "Mr. Market" is an obliging business partner, always willing to publicly quote his price to buy or sell a company. That price, while known to the public, is not always a true representation of the underlying worth of the company. In September, when Philip Durell recommended First American (NYSE:FAF) to Inside Value subscribers, its shares were well below their fair value, trading at $29.08 the day the newsletter was released. The market feared higher interest rates would punish housing-related companies, and as a title insurance company, First American had been in the dumps with the rest of the sector. Philip made a compelling argument that First American was worth closer to $38 than $28, despite Mr. Market's worry about the impact of potentially higher interest rates. As of this writing, the company trades near $35, up better than 20% and much closer to its intrinsic worth. An objective investor, looking beyond short-term factors, could have profited handsomely from this investment.
Staying when others jump
Additionally, a value investor needs to be confident in his or her analysis. When Pfizer (NYSE:PFE) disclosed studies indicating high doses of its arthritis medication Celebrex were linked to heart trouble, the company's market capitalization shrank more than 11% in a day. The sell-off was driven by comparisons between Celebrex and Vioxx, a similar compound manufactured by Merck (NYSE:MRK). Links between Vioxx and heart issues had recently led Merck to pull the drug, resulting in a series of lawsuits. But a confident investor who read past the Celebrex headline and through the entire story would have noticed significant differences between the two situations. Such an investor could have reasonably held Pfizer through the momentary hiccup, or might even have bought during the dip. Now that the market has had time to digest the full Celebrex story, Pfizer's market value has largely recovered, rewarding the confident investor -- not the investor who panicked and sold, losing a significant amount of money.
Doing the time
To illustrate the third virtue of value investors, look no further than Motley Fool co-founder Tom Gardner. As Tom pointed out, a large part of value investing is buying companies worth more than their current market price and then waiting for something good to happen. Patient investors in Masonite International (NYSE:MHM), another of Philip's Inside Value picks, were rewarded recently when the company announced that Kohlberg Kravis Roberts intended to buy it for $40.20 Canadian (about $32.40 U.S.). That is nearly a 30% premium to the $25.12 at which the company had been trading when it was first recommended to newsletter subscribers in September.
Putting it all together
Often, a value investor requires all three attributes to be successful. For example, when I uncovered home builder Lennar (NYSE:LEN) in August, I estimated its fair value to be around $59.33 per share. At the time, it traded at $42.77, 28% below my calculated value. Trying to be objective, I based my valuation estimate on a conservative discounted cash flow analysis of the company. Along the way, interest-rate fears, pricing problems in the Las Vegas housing market, and a delay in delivering 600 homes tested my confidence in my analysis. Knowing my estimates to be conservative, however, I managed to soldier forward. Eventually, I determined the stock still looked like a value in mid-November. Finally, after Lennar reported record earnings in December, my patience was rewarded. The company's price has risen and now trades much closer to my estimate of its intrinsic value.
Every once in a while, the folks on Wall Street do odd things, like offer three tens for a twenty or accept two twenties for a fifty. Value investors with the right mix of objectivity, confidence, and patience can often profit from the Street's mistakes.
Fool contributor Chuck Saletta owns Merck and Lennar Class B shares. The Motley Fool is investors writing for investors.
