Buy the Steak, Not the Sizzle

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

"Sizzle," a.k.a. hype, is everywhere, particularly 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; not many CEOs would advertise their stocks as overvalued. So when a young company with great prospects comes out, all the buzz is buy, buy, buy: "There's huge market potential. Sales are rising. Look for 100% earnings growth. It's a buy at any price." You know all those stories about unlimited growth? Fo' shizzle, that's the "sizzle."

Here's a reality check: Not every company will 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. (It would be wonderful, of course, but it's not necessary.)

You know the best companies. They have powerful margins. They generate great returns on invested capital. They create substantial amounts 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? I'm not going to lie to you: It's not easy, and you need the right mindset. But it is possible, and the rewards can be fantastic. Here's one proven way to do it: Order the steak after the sizzle has worn off.

Even the best make mistakes
As I said, you already know the best companies. They have proven track records. Business schools write case studies about them, and they typically sell at a premium. But Fools who subscribe to a value-oriented philosophy know that 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 a McDonald's (NYSE:MCD) hamburger.

AES (NYSE:AES) and Procter & Gamble (NYSE:PG) were on top of the world in 2000. So were Tyco (NYSE:TYC) and Capital One Financial (NYSE:COF) in 2001. These four great stocks were near all-time highs. Then things changed.

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 generation plants.

Procter & Gamble had several problems. First, it failed to be a "white knight" for Warner-Lambert when Pfizer (NYSE:PFE) wanted to acquire it. P&G issued an earnings warning in March 2000 that sent the stock down 30% in a single day. Combine that with rising material costs and the announcement of a huge restructuring plan, and it's easy to see why investors fled.

I imagine most people know the follies of Tyco. Its business strategy was based on defragmenting fragmented industries, which by itself is a great idea. As such, it acquired lots and lots of businesses to build out its diversified manufacturing base. When questions were raised about its acquisition accounting, investors took notice. Then the CEO was caught raiding the cookie jar and abruptly left amidst a tax-evasion investigation. Investors promptly followed Kozlowski to the exit.

Capital One was making money hand over fist in the sub-prime lending business. When a story broke announcing that Capital One was expected to enter an agreement with banking regulators over its loan reserves, fear abounded. The consensus was that earnings growth would surely take a hit. The stock plummeted 40% in one day.

The best bounce back
Were these scrawny companies truly lacking meat on their bones, with only a sizzling story to their credit? Hardly. These companies were all prime, grade-A choices.

So why were they punished? It was a combination of plain old mistakes and out-of-whack expectations that could not be fulfilled. You see, the sizzle is often oversold -- and as soon as something goes wrong, investors head for the hills. (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, yet they were sold off heavily. The market was almost giving their value away. These companies had solid game plans and plenty of room for growth. Investing during the worst of times would have produced the following returns:

Let's face it, the great companies bounce back because they are great. They have advantages that are difficult to replicate or replace. But it's 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.

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 loads 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 understanding what makes great companies great, and buying them during the narrow windows of opportunity in which they're underappreciated. It's about being a contrarian. 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 such opportunities. The record shows that value investing has outperformed the market over the long haul. If you'd like free access to every pick Philip has made, try Inside Valuerisk-free for 30 days. Philip knows that to outperform the competition, you have to look in places where others fear to tread. 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 -- which comes 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.

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

David Meier owns shares in AES but not in any of the other companies mentioned. Pfizer is a Motley Fool Inside Value recommendation. The Motley Fool has adisclosure policy.