The late, great Will Rogers once said, "I'm not nearly so concerned about the return on my capital, as I am the return of my capital." That's a sentiment shared by almost all investors. The problem is, however, that assuring that an investor will get all his or her money back comes at a guaranteed cost. And that cost is the slow, steady, and unstoppable loss of purchasing power due to inflation.
To add insult to injury, money kept in an ordinary savings account or other "sure thing" investment is not only losing ground to inflation every year, but whatever minuscule interest on it gets taxed at ordinary income rates. The twin terrors of inflation and taxation dictate that about the only way to get ahead financially is to invest.
Yet there's still the nagging problem of risk. There are no guarantees in the stock market, and there is little more than history and faith in the abilities of businesses to grow to forecast the probability of long-run success. If an investor wants a positive return on an investment after taxes and inflation, that investor must take risks. Not all risks are created equal, however, and that's where value investors like Warren Buffett, Benjamin Graham, and The Motley Fool's own Philip Durell at Inside Value get their edge.
The Wise in the financial industry talk at great lengths of the risk/reward trade-off. According to their statistical models, risk and potential reward grow together -- the higher the risk, the higher the potential reward, and vice versa. While that's true to some extent, it relies on the incorrect assumption that stocks are always fairly priced.
That assumption is simply not true, as history has shown time and time again. The market is not an efficient forecaster of the future, and stock prices do not necessarily accurately reflect intrinsic values. Were the market efficient, the high-technology Nasdaq bubble would never have formed, much less burst. While value investing cannot eliminate the risk side of the equation, it can help investors find companies where the potential for reward is greater than the risk priced into the stocks. And by diversifying across a range of these mispriced securities, the value investor's chance of overall success further improves.
While very few companies pass the value test at any given time, there are always some values lurking in the market. The big question, of course, is how to find those companies. Where should someone look to find the rare company that can provide superior risk-adjusted returns over time? Amazingly enough, the answer can often be found in the companies behind the products and services of everyday life.
Coca-Cola (NYSE:KO), a recent Inside Value recommendation, has one of the best-known brands on earth. As Coca-Cola has been facing relentless competition from archrival and fellow household name Pepsi (NYSE:PEP), its shares recently fell on relatively hard times. To many value investors, the weakness of Coke's recent stock price, coupled with its globally powerful brand, simply presented an offer they couldn't refuse.
Another behemoth of a brand, McDonald's (NYSE:MCD), could be bought at the bargain basement price of $12.38 per share back in March 2003 -- less than what a family would spend there on dinner. A combination of concern about the company's tendency to cannibalize existing store sales with its new stores, competition from the likes of Wendy's (NYSE:WEN) and its 99-cent value menu, and the disastrous "made for you" system that managed to slow down service at the restaurant that practically pioneered fast food had all conspired to knock the Golden Arches down a few notches. Since then, through the turnaround started by the late Jim Cantalupo, its shares have nearly tripled, recently closing at $33.28.
That's a tremendous market-beating return from what had already been one of the biggest brands on earth. The market had been pricing in tremendous risks -- risks that the company would never recover from its stumbles. Back when things were at their bleakest, there were even fears that McDonald's would go the way of Kmart (NASDAQ:KMRT), knocked down by more nimble competitors, unable to right the once-great corporate ship in time to prevent a catastrophe.
Even Kmart is now a success story of sorts. Upon its emergence from bankruptcy, the formerly huge discount retailer that had been beaten up by Wal-Mart (NYSE:WMT) became prized not for its improved operations, but rather for its tremendous real estate assets. As an older retailer, Kmart owns land in what are now prime locations, and by selling its stores off piecemeal, it has earned significant profits from its real estate operations.
While it's an odd model for a retailer to sell its stores instead of its merchandise, it's currently working for Kmart. Its shares have responded so well to it, in fact, that the company is using its stock as an acquisition currency to pick up Sears (NYSE:S), another well-known retailer whose stock and business have fallen on hard times as of late. Not bad for a company just a couple of years out of bankruptcy.
Would it have been risky to buy Kmart shares just as it emerged from bankruptcy? Absolutely. There were no assurances that the company would be successful competing against Wal-Mart, even with its bankruptcy-scoured balance sheet. Emerging from bankruptcy as Kmart did, however, with a share price so far below its book value, indicated that the company was worth more dead than alive -- a genuine cigar butt investment opportunity.
When opportunities like that arise, value investors know that the risks have been dramatically overstated. When risks are overstated, a company's stock tends to trade below its true value. And in buying a company trading below its true value, investors have the opportunity to profit in excess of what they otherwise would.
As happened in the cases of McDonald's and Kmart, once the market realizes that it had mispriced a firm's stock as riskier than it truly was, it will remedy the situation by bidding up the stock closer to its fair value. By being patient enough to wait for the market to realize its mistake and rectify the price of the undervalued firm, value investors can get the best bang for their investing bucks. That's why value wins, time and time again.
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Fool contributor and Inside Value team member Chuck Saletta has no investment in any of the companies mentioned in this article. The Motley Fool is investors writing for investors.
