Buy the Steak, Not the Sizzle

I don't know whether Philip Durell, lead analyst for the Motley Fool Inside Value newsletter, is a Seinfeld fan or not, but I know he would appreciate Kramer's words while "working" for Brand/Leland: "You don't sell the steak. You sell the sizzle."

"Sizzle," aka the story or hype, is everywhere early in the life of great companies. Wall Street uses it to get its promotion machine to generate transactions. Executives hype up their companies because it's their job; no CEO in his right mind would advertise his stock as overvalued. So when a young company with great prospects comes out, all the buzz is buy, buy, buy: "It's going to grow earnings. It's going to grow the top line. EBITDA is on the rise." You know all those stories about unlimited growth? That's the "sizzle."

Unfortunately, not every company can be the next Microsoft (NASDAQ:MSFT). But guess what? You don't have to find the next Microsoft early in its life cycle to generate great returns. You know the best companies -- the ones that allocate capital Foolishly, generate excellent returns, and have plenty of room to grow. They create lots of free cash flow that they reallocate Foolishly to keep the cycle going. We'll call these the "steak."

Can you navigate through the sizzle in order to find that choice cut of steak? Although it's not always probable, it is definitely possible. But you know what else you can do? You can order the steak when it goes on sale -- after the sizzle has worn off.

Even the best make mistakes
The best companies are easy to spot. They have proven track records. Business schools write case studies about them and they typically sell at a premium. But fortunately for Fools who subscribe to a value-oriented philosophy, nothing in life is perfect. Even the best companies make mistakes, run into trouble, or have to make tough competitive choices. And this is when we get the chance to buy a prime cut of Angus beef for the price of McDonald's hamburger.

Have you ever been in a crowded city but felt alone because no one knew who you were? Sometimes great companies feel the same way. They are in plain sight, and yet no one pays attention to them.

In 2000, Dell (NASDAQ:DELL), McDonald's (NYSE:MCD), and AES (NYSE:AES) were soaring. These three great companies were near their all-time highs. They were the poster children for American capitalism and their prospects were never better. Then, things changed.

Dell was slashing prices at the same time it was extending its product lines. Growth was slowing, and the threat of a price war from the competition was very real. As a result, the stock fell 71% from its all-time high.

McDonald's also experienced slowing growth. Consumers became more conscious about eating healthier. Critics complained that its menu was boring and predictable. Management decided to venture into things too far outside of their circle of competence of sandwiches and fries. All of this resulted in a 74% decline from its all-time high.

AES dropped from $70 to $1 as it began to experience slowing growth, got caught up in the fallout from the Enron collapse, and felt the pain of foreign currency collapses in South America, where it owned some generation plants.

And then there's MO
Altria Group (NYSE:MO) -- back then known as Philip Morris -- experienced the same thing, only a year earlier. At the turn of the century, who wanted to own a stodgy old tobacco and processed food company with a boat anchor of lawsuits weighing it down when you could own high-flying technology companies and double your money in months rather than years? Apparently no one did, as the stock was off 68% from its high.

The best bounce back
Were these scrawny companies without any meat on their bones, made up of only a sizzling story? Hardly. These companies were all meat -- prime, grade A, U.S. choice.

So why were they punished? It was a combination of out-of-whack expectations that could not be fulfilled and a stumble. You see, many times, the sizzle gets oversold. And as soon as something goes wrong, investors head for the exits. (This is where I'm supposed to insert a witty comment about the irony of markets being efficient. You're Foolish. You know they're not.)

Like I said, everyone knew these companies were plenty meaty. And yet they were sold off heavily. The market was almost giving their greatness away. These companies had solid fundamentals, solid game plans, and plenty of room for growth. Investing in them during the worst of times would have produced the following returns:

Let's face it, the best companies bounce back because they are best. They have advantages that are difficult to replicate or replace. But it is so easy to get caught watching for "the next big idea" or "the next category killer" and miss the opportunity to invest in solid companies when no one wants them. Finding the superstars of tomorrow certainly is sexier than waiting for great companies to make mistakes. But remember, lottery winners take home huge sums of money because the odds are stacked severely against them.

The value myth
There are two huge misconceptions about value investing. The first is that it's boring. Who wants to brag about buying an undervalued company? There's rarely any news coverage about undervalued companies because there's no sizzle to sell the newspapers and magazines. But I, for one, have never found solid investment ideas boring.

The second misconception is that value investing involves sifting through lots of data and ratios. But don't think of it in terms of low price-to-earnings or low price-to-book ratios -- it's so much more than that.

Value investing is about finding great companies that are underappreciated for a limited time. It's about being a contrarian and going against the grain. It takes guts, as well as the ability to look through the misery in order to assess just how much meat is on the bone.

That's where Inside Value can help
Philip Durell and the Inside Value team are always on the lookout for the best opportunities. Philip knows that to outperform the competition, you have to look in places where others fear to tread and think differently about the best way to invest your hard-earned capital. For good reason, you won't find a whole lot of sizzle in the Inside Value portfolio. That's because Philip is more than happy to wait for the right opportunity to invest, after the sizzle dies down. He doesn't know when the next great company will fall from grace. But he will be there to find it when it does.

The record shows that value investing has outperformed the market over the long haul. To see how Philip Durell is beating the market by finding meaty companies, try Inside Value risk-free for 30 days.

This article was originally published on Feb. 9, 2005. It has been updated.

Fool contributor David Meier owns shares in AES but not in any of the other companies mentioned. The Motley Fool has a disclosure policy.