I'm going to tell you something the money managers out there don't want you to know. It's possible to beat them at their own game. Remember, the majority of funds out there underperform the market indexes over time -- this despite being run by people with four-digit IQs and millions of dollars' worth of adding machines.
That's why we've long advocated picking your own stocks. What's more, you can stack the odds even further in your favor by going the value route.
I know, I know. Value investing seems complicated. Book value? Return on capital? Discounted cash flow? Margin of safety? Most people would rather buy high and hope it goes higher than put a pencil to paper or read an entire annual report. But if you really want to beat the market with less risk, you'll need to start investing like a grown-up and learn how to use these tools.
Relax. It's not that hard.
Philip Durell, the admiral of our bargain-stock newsletter, Motley Fool Inside Value, has even told me that he is confident -- in fact he actually hopes -- that his readers will become so skilled at value investing by following his teachings that they eventually won't need to subscribe. (He also hopes that they'll find it useful enough to keep subscribing anyway, but that's another story.)
While you'd get a more thorough introduction to this process by taking a free trial to Inside Value, a few simple steps should shed some light on the methods behind this madness. I use them in my own investing, and if I (an art history major) can do this, anyone can.
Follow the garbageman
You know the old saying: One man's trash is another man's treasure. This is particularly true in the stock market, where sentiment turns very quickly and good companies can be relentlessly whacked for even minor hiccups. IBM's (NYSE:IBM) recent troubles, I would argue, were a bit more than minor. But even those of us who doubted Big Blue -- and I was one of them -- were forced to take an extra look as the share price cratered over the past few months.
Was IBM really worth 30% less in April than it was four months prior? I didn't believe so, and I doubt that most of the smart money out there believed it either. But smart money sold like crazy anyway. Remember, there's plenty of money out there that's run by intelligent people who lack motivation. They're only interested in looking good over the short term. To them, it's more important to be right next month than right two years from now. (You can't blame them, really. After all, they've got to answer to jumpy investors, with all their hysterics and gnat-like attention spans. Underperform for a month or two, and these folks will take their toys elsewhere.)
But this is exactly the kind of knee-jerk reaction that creates value for the rest of us. Since you only need to answer to you, there's no need to worry about jittery investors withdrawing their money and taking it elsewhere -- you can take advantage of the Street's fits. Sifting through the market's trash will yield bargains nearly every time.
Do
your homework
Make no mistake. You do need to sift through the refuse. Sometimes that two-legged chair is just that -- an unfixable two-legged chair. It's only by taking a look at the numbers and making some judgment calls that you can figure out what a stock is worth to you. Pier 1 (NYSE:PIR), for example, is something that's long looked cheap, even to investors who work for the lofty likes of Warren Buffett at Berkshire Hathaway.
It's never looked like a bargain to me, with sales on the skids and little relief in sight. I can easily imagine a world without Pier 1, and for that reason alone I'd need to see a bigger discount before I'd put my own money on the line. In value investing, you have to think for yourself, even if Berkshire (with its Midas touch in investing) is pouring money into something.
Stand firm
You might think it sounds a bit pompous for me to trash a stock that's gotten Berkshire's blessing, but stubbornness (within reason) is something you need to develop to become a value investor. Buying shares that everyone else is shedding requires you to stubbornly believe that you are right and all those other folks are wrong.
That's how investing fortunes are made. It's how I cashed in on a big, unwarranted slide at Chico's FAS (NYSE:CHS) last fall. It's the kind of call Philip Durell made on Home Depot (NYSE:HD) when the stock hit the skids back in early 2003. It doubled within two years. And to show you that great minds (Philip's) sometimes think like lesser minds (mine), we both pegged this juggernaut as an undervalued bargain this spring. Since it entered the Inside Value scorecard, it's returned 17% -- a year's decent returns in just a couple of months.
Buy what you know
Value investing as some practice it can be pretty complex. For instance, hunting for retailers or other companies whose real-estate holdings might be worth significantly more than their value on the balance sheet will take some time. If you're interested in that kind of thing, and have the chops to pull it off, hey, knock yourself out. Valuing a giant company like GM (NYSE:GM) in pieces, as my colleague David Meier did a while back, is also a task for the brave. But you can forge your own path.
Me, I look for simpler situations, most often a manufacturer or retailer that is turning around from a period of underperformance or that is simply out of favor on Wall Street for reasons unknown. Abercrombie & Fitch (NYSE:ANF) and Guess? (NYSE:GES) are examples of the first. Don't get me started on Abercrombie. It's too painful to remember how I highlighted the stock for Fool readers last Halloween, then neglected to buy the shares myself. Back then, I pointed out that even without a big sales turnaround, the stock was a bargain based on cash flows alone. Moreover, because my wife's a teacher and spends plenty of time with the teen denim scene, we knew Abercrombie was still the brand of choice, and that sales were not going to stay down forever. Surprise, sales did return. Then the stock shot up and never looked back. I've been watching for 100% or so. Ugh.
I've fared better with Guess? Its sales were steady and increasing at a stable but uninspiring rate. But operational efficiency was improving greatly, so that minor improvements in margins would bring good things to the bottom line. By the way, my wife brought me this idea, complete with a thumbnail discounted cash flow (DCF) valuation -- which she created using Inside Value's handy DCF calculator. She's very smart, but she's no stock-o-phile, by which I mean that anyone can win at this game. Guess? has returned better than 30% for us since she found it, and I expect more to come.
The final word
Take it from me, the art history major: Value investing is not beyond your abilities. As Buffett has always explained, intelligence isn't the stumbling block for anyone's investment accomplishments. Homework is important, but in the end, it's the discipline to remain steadfast and the guts to buy when others are fearful that will make you more successful than the experts.
If you'd like to look at the Fool's top value picks, and learn more about scary-sounding concepts like book value, return on capital, and the all-important margin of safety, a free trial of Motley Fool Inside Value is just a click away.
For related Foolishness:
- It's not too late to start investing like an adult.
- Value is not as rare as you think.
- It may not have been wise to dump Home Depot.
Seth Jayson has always done better catching falling knives than riding the wave up. Go figure. At the time of publication, he had shares of Guess?, but no financial position in any other company mentioned here. View his stock holdings and Fool profile here. Fool rules are here.
