I'm not the type of person who wakes in the predawn hours of Dec. 26. My wife is, though. She rises early, pours her coffee, tucks the newspaper inserts under her arm, and drives to the local mall in time for the opening doors. All in the name of a great bargain.
Although I slumber through her wake-and-shop strategy, don't misunderstand: I appreciate it. Especially when I'm a beneficiary of her deal-wrangling.
Understanding when, where, and how to unearth the bargains is best left to pros -- anyone who has ever been to a crowded mall knows it's no place for amateur acts. In this vein, shopping the market is no different than retail shopping. Here at the Fool, we adopt a similar strategy to investing: we want bargains. With Motley Fool Inside Value, that aim comes to print, with a seasoned pro at the helm.
Get 'em when they're down
In his interview with Motley Fool co-founder Tom Gardner, Inside Value advisor Philip Durell remarked that the strategy behind value investing is to "look for stocks that others aren't interested in, ones that are being dumped by institutions, downgraded by analysts." The most common places to find such value are in big, stalwart companies that have hit a rough patch (nearly two years ago, McDonald's (NYSE:MCD) would be a case in point); former growth stocks that have slowed down (think Home Depot (NYSE:HD)); or companies with really serious troubles -- tainted by the "b" word (bankruptcy) and/or that nasty acronym, SEC (attention, Kmart (NASDAQ:KMART) shoppers).
After a healthy dose of homework and a thorough valuation show that the right company is for sale at the right price, the Inside Value team applies Benjamin Graham's margin of safety to any buy price. "We demand healthy discounts before buying," Durell says. So, then, a good value investment is not just to buy cheap, but to buy cheap after extensive homework.
Which, of course, is easier said than done....
Enter the contrarian
The captain of the Inside Value ship is no ordinary analyst. As Tom Gardner -- an active reader of Inside Value himself -- has said, "Philip represents the best of what we are doing" at the Fool. As the adage goes, the proof is in the pudding: Durell won the 2004 Feste Award, given to the most valuable member of The Motley Fool Online community, as voted by our worldwide list of members.
A former executive in seaport enterprises across the globe, Durell's specific expertise was in corporate turnarounds. He had a hand in the whole spectrum -- operations, marketing, finances -- which, he says, has been a great advantage in separating the sinkers from those that just need a swimming lesson.
Durell bought his first stock back in '68 -- the year Tom Gardner was born -- so he's been through the ups and downs of Wall Street. As lead analyst for Inside Value, he is, in his own words, "responsible for leading members to superior returns and for preparing the group in advance to deal with the inevitable storms."
Thus far, Inside Value has nearly tripled the success of the S&P 500 -- superior returns indeed.
Do you believe in MGIC?
When a bargain enters the radar screen, Durell puts the potential buy through a series of metrics. Value investing requires that investors trust their research and calculations -- what we'll call their "homework." One of Durell's most satisfying value investments remains MGIC Investment (NYSE:MTG). The nature of MGIC's industry, private mortgage insurance, caused many analysts to devalue it. Durell came to a valuation of approximately $70; when he bought it was selling at $44. Shortly after buying in, the stock fell 20%. Durell went back to his valuation, checked his math, and decided that it was still worth $70 -- so he purchased more shares at the discounted price. Since then, the stock has hovered around $70 (most recently, it is just south of $65).
The MGIC example highlights five steps of a great value play:
- Buying when others hate an industry.
- Being willing to accept a short-term fall in the price.
- Going back through your work after the price has fallen.
- Buying more at a deeper discount.
- Sitting back and letting the value of the business emerge.
According to Durell
If your knees turn weak at the sound of terms like bankruptcy or SEC investigations, perhaps you should linger behind the curve of consensus stockpicking. (Although I'd be remiss if I didn't point out that those returns are so average.) With value investing, you have to capitalize on Wall Street's sometimes irrational mood swings. Is the market sometimes correct in undervaluing a stock because of, say, patent expiries? You bet. Would it have been stupid to buy Enron on its way down? Absolutely. Informing yourself will help you recognize the discrepancy.
Durell requires several things from an attractive value investment: a solid management team, attractive tangible assets, cash flow, as well as a catalyst (or a perception of a catalyst) that will force the market to eventually recognize the value of a company. The first thing to look for is a change of management -- what's the past performance of the new management team? Are they on the up-and-up? Second, the business must have great assets and a strong balance sheet. And finally, how much cash does the company produce? An attractive company has plenty of cash and not much debt.
Durell's value approach gives investors a chance to add some large- and mid-cap stocks (the low end would be companies with a market cap of $500 million) to their portfolios, which are less volatile than the average growth stock, and will be the kinds of stocks to hold for the long term.
Put your money where your math is
The philosophy behind value investing demands two things from investors: They must first do the research, and they must then stick to their guns. "If you really believe in your estimation of the company's future prospects and your own valuation, don't bail out," Durell advises. "If the stock slips, double down on your homework, and buy more if you confirm your earlier assumptions.... Be willing to extend the position when you've really done your homework and feel confident."
Durell identifies the price-to-earnings (P/E) ratio as one useful starting point, also urging investors to invert the ratio and examine the earnings-to-price numbers. "This just provides some helpful context. A company that's got a price-to-earnings ratio of 25, when we invert it, that means the return is 4%. So for every dollar you put in, you're expecting to get 4%." Regardless of other factors, history has shown that stocks with lower price-to-earnings ratios yield higher returns.
Among other metrics that Durell inspects is the enterprise value-to-free cash flow ratio -- a particular favorite because it "forces me to think about buying the whole company." It's easy to forget the basic tenet of buying a stock: that it represents ownership of a business. "If you work valuations off the enterprise value of a business, you really see the price of the whole company you're considering buying a stake in." A low price-to-book-value, lots of cash, and a low price-to-sales ratio are all handy tools for determining the value of a company.
Or, you can put the calculator down and let Philip and the Inside Value team do the legwork for you. Even that's a bargain: Click here to sign up for your free 30-day trial. We promise no one will make you get up early for this deal.
For related Foolishness:
- To read the full transcript of Philip's interview with Tom Gardner, click here (a free trial to Motley Fool Inside Value is required).
- Make it your mantra: margin of safety.
- Find out how you can profit from bankruptcy.
Though Brian Richards does not like to shop or wake up early, he does enjoy good bargains and travel mugs full of coffee. He owns none of the companies mentioned in this article. Check out the Fool's disclosure policy here.
