Have you ever found a quarter just lying there on the ground at the shopping mall? How about a dollar bill trapped in the grate covering the storm sewer? Ever taken up the cushions on your couch and found a handful of change? We've all done it -- we've all found money, just sitting there, waiting to be grabbed. And if you've ever seen that money, picked it up, and said, "Cool, free cash!" then you have the makings of a value investor.
At its essence, that's all value investing really is -- the act of finding free cash lying on the floor of the stock exchange. Hard to believe, isn't it? But it's true. Let's take a second to consider the quarter lying on the ground of the mall. Did you ever stop to think about how you ended up with that quarter? First of all, somebody else once had that money. And that person lost track of it. It may have slipped out of a pocket, fallen out of an open change purse, or was just plain dropped on the ground by someone who didn't think it was worthwhile to pick back up.
Once that quarter fell, it became fair game for anyone who bothered to look. Yet countless numbers of people passed by between the time the quarter fell and the time you bothered to retrieve it. Those folks either weren't looking for the free money or weren't interested in stopping to pick up such a small amount of cash. Whatever the reason, you were there, you seized the opportunity, and now you're better off for it. Their loss, your gain.
Value investing works in much the same way. Something triggers investors to sell their stakes in a company for far less than they're worth -- in essence dropping quarters left and right in an attempt to "rescue" as many dollar bills as they can. A value investor can take advantage of that needless panic, often finding a treasure trove of found money in the discarded stocks.
Who drops the cash?
Much of the time, the largest institutions are most guilty of throwing away good money. The mutual fund houses such as American Express (NYSE:AXP), Franklin Templeton (NYSE:BEN), and Legg Mason (NYSE:LM) are all likely to drop quarters while concerning themselves primarily with the folding currency. When you're dealing with hundreds of millions, or even billions, of dollars, a lot of pocket change tends to get lost in the shuffle.
Why do they drop it?
As mutual funds and institutional investors, they're governed in part by guidelines and prospectus requirements that do not affect the individual investor. For example, when ketchup giant H.J. Heinz (NYSE:HNZ) lowered its dividend in 2003, any mutual fund whose prospectus indicated that it invests in companies with stable or rising dividends was forced to sell. Regardless of what Heinz's real value was (and is), as the company's business changed, institutions that owned the stock had to sell to keep in line with their prospectus.
Who ignores the money?
Once again, the big institutions are hampered by their own rules and regulations. This time, though, it's the index funds such as Vanguard 500 Index (FUND:VFINX) and the Diamonds (AMEX:DIA) ETF that are simply unable to take advantage of the opportunity presented to them.
Why do they ignore it?
As index funds, they are required to mirror the index they track as much as possible. It doesn't matter if toy giant Mattel (NYSE:MAT) was a screaming buy last August, when value guru Philip Durell recommended it in his Motley Fool Inside Value newsletter service. The index trackers simply could not back up the trucks, overload their funds with Mattel stock, and wait for the recovery that has now hit full swing. It would have broken the prospectus that governs their behavior, despite the advantage to their investors if they had done so. Mattel was so undervalued, in fact, that in spite of its recent poor earnings report, its stock has outperformed the market since Philip made his selection.
Why value wins
These institutions make up a huge chunk of the market: in 401(k)s, pension plans, mutual funds, and university endowments. Every single dollar these institutions invest is governed by rules that simply do not apply to individual investors. And each of these rules, no matter how much they're meant to protect the ultimate beneficiaries of the money, can and do force those institutions to occasionally make bad decisions.
As a value investor, you're free to buy, sell, or hold based on comparing a company's intrinsic value with its market price. If a stock is on sale, you can buy it. If it looks likely to crash because it's dramatically overvalued, you can sell it. Your rational mind, not your emotions or some obligation to a prospectus, is in charge of your decisions. This gives you -- the little guy -- a tremendous advantage over the big-money institutions that make up most of the market.
Since so much of the money invested in the market is stuck in these institutions, a lot of money is dropped on the floor of the exchange. A few quarters dropped here and there by a single fund may not mean much, but multiply it by the thousands of funds that are trapped by enforced bad decisions. The total can add up to a significant stash of found cash for the individual willing to take advantage of the situation.
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This article was originally published on March 11, 2005. It has been updated.
Fool contributor and Inside Value team member Chuck Saletta owns shares of Mattel. The Motley Fool is investors writing for investors.
