Valentine's Day is just around the corner, and love is certainly in the air. Love of one another may bring a lifetime of happiness to men, women, and families around the world. In investing, however, love is often dangerous. As value investors know, in fact, it's often better to buy the unloved and unappreciated companies in the market.
Take bankruptcy survivor and telecommunications giant MCI (NASDAQ:MCIP). In August 2004, it was certainly unloved, which made it a perfect inaugural pick for the Motley Fool Inside Value newsletter. At the time, the market discarded MCI because of strong competition and declining revenues. With a bankruptcy-scoured balance sheet and a large, entrenched business, however, the company was ripe for the picking. Up more than 50% from its recommendation price in just a few short months, the market certainly realized its mistake in previously casting off MCI.
Cupid's busted arrows
Speaking of phone companies, there was a time when AT&T (NYSE:T) was considered the quintessential "widows and orphans" stock. The company had a government-supported monopoly that assured both market dominance and a solid return on investment, with a well-supported dividend that assured decent income for shareholders. "Buy it and forget it" was the mantra of the era. Now, "Ma Bell" seems a shadow of her former self. The company that formerly ruled the telecommunications world is now so frail it's being taken over by its progeny SBC Communications (NYSE:SBC), a "Baby Bell" that was once merely a regional spin-off of the original AT&T.
Likewise, Xerox (NYSE:XRX) once ruled the photocopying realm. Indeed, the phrase "make a Xerox" became synonymous with the act of duplicating images on a photocopier, much to the delight of Xerox's marketing department (but to the chagrin of its copyright lawyers). Yet thanks to a failure to defend its position, the company's stock currently trades about where it did in the early 1970s. In the meantime, former upstarts such as Canon (NYSE:CAJ) have competed fiercely in the market Xerox used to handily dominate.
AT&T and Xerox were at one time considered among the supreme pinnacle of companies -- they were "one decision" stocks. These companies were thought to be so dominant and so immune from competition that investors were counseled to buy them, forget about them, and just trust them to perform over time. Unfortunately for long-term investors, the businesses failed to keep pace over time, and both have significantly underperformed the S&P 500 over the long haul. The sagas of these once-great firms indicate the importance to investors of continuing to do their homework and research the real prospects, opportunities, and threats facing the companies they own.
Prudent portfolio pruning
In order to avoid being trapped in perpetuity in a "one decision" investing mistake, an investor must be objective enough to place a value on what a company is worth. That intrinsic value becomes the centerpiece of the investor's strategy, the number around which buy, hold, and sell decisions are made. That's right, I said that typically forbidden term on Wall Street -- the "S" word. Remember that all a share of stock represents is an ownership stake in a firm. Don't fall in love with the company or its stock -- treat it like a business, like a tool for making money. It's not a lifetime partnership, not a marriage.
Benjamin Graham, the dean of value investing, taught of the margin of safety -- a discount at which a company could be bought to provide the investor with the potential to earn a superior risk-adjusted return. Graham's margin provides superior upside potential, as well as a measure of downside protection. It follows, therefore, that the opposite is likely true. If a firm trading at a discount to its fair value means better upside potential and lower downside risk, then a company trading above its intrinsic worth would carry with it higher downside risk and lower upside potential.
The sell decision needs to happen, and it needs to happen based on the fundamentals of the company. If a company is trading below its intrinsic value, that's a good reason to buy more. If it's trading at or around its intrinsic value, it's certainly permissible to hold. But if an investor owns a company that is trading dramatically above its intrinsic value, it's time to take some cash off the table and put it to better use elsewhere.
In January, I warned of the carnage happening at Taser International (NASDAQ:TASR), a stun-gun company that itself had been stunned by a combination of an SEC investigation, a delay in its orders, and a new onslaught of competitive pressures. The day that article was published, Taser closed at $19.64. Since then, it has continued to slide, recently closing at $15.22. That's an additional 22.5% loss from its valuation as of that date, and a total drop of about 55% from its high of $33.45 in December 2004. Taser is a strong brand and a market leader, but so is Cisco Systems (NASDAQ:CSCO). And as investors who bought Cisco near its high in 2000 now painfully know, market leadership and brand strength only take a company's stock so far. At some point, the company's fundamentals take over, and valuations return to rationality. Cisco was overpriced in 2000, and Taser was overpriced in late 2004.
Eventually, something will trigger the market to reevaluate the euphoria surrounding high-flying company stock prices. The time to get out is before that bubble bursts. And the only reliable way to do that is to have an idea of what price a company's fundamentals justify, and then sell if its price can no longer be rationally justified. A person following this advice may have sold Cisco in early 1999, missing the last gasp of the bubble run-up. But that person would also have missed the tremendous burst that followed.
Opportunities still knock
Fortunately for the value-seeking investor, there are always a few bargains waiting in the wings -- places to invest the windfall profits from selling the companies that aren't worth holding. To quote Philip Durell, chief analyst for Inside Value, "I won't concede that there was a time -- ever -- when a bargain or two didn't lurk somewhere in the market. Value is out there, even when whole groups of stocks get ahead of themselves." It really isn't too difficult to find value and avoid the worst of the wreckage of a meltdown -- it just takes a combination of data-driven analysis and a willingness to never fall in love with a stock.
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Fool contributor Chuck Saletta has no investment in any of the companies mentioned in this article. The Motley Fool has a disclosure policy .
