Waiting on Greatness

One of the toughest lessons to learn as a value investor is how often it is absolutely critical to do nothing but sit and wait. Watch the grass grow as the market goes through its daily acrobatics and shoots your portfolio all over the place (as it probably has the past few days). As difficult as it may be to do absolutely nothing, it's only through waiting that we individual investors have a shot at beating the market.

When value investors swoop in to buy shares of a company, there's often something seriously wrong with it. Take government-sponsored mortgage giants Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE), for example. Both were hit hard by accounting scandals, both are facing congressional ire and the potential for stronger regulations governing their businesses, and both are staring at uncomfortably narrow yield curves and quality spreads. Predictably, the stock of both companies has been pummeled lately. While both look likely to survive this round of attacks, until the storm settles, investors will probably have to face even more pain.

Likewise, the Vioxx-induced liability surrounding pharmaceutical giant Merck (NYSE:MRK) currently hangs like an albatross over its market value. Fellow drugmaker Pfizer (NYSE:PFE) may not be immune to similar lawsuits, as its Celebrex and Bextra come from the same class of compounds as Vioxx, leading to speculation that they, too, may eventually be shown to cause adverse cardiac events.

The market's machinations
Although all of these companies face serious issues, value hunters have started to peck. The reason is simple. In the short term, the stock market is a very volatile and unpredictable place. Stocks go up and down on good news, bad news, or even no news at all. Yet over longer periods of time, the market tends to eventually price companies pretty close to what they're worth. Benjamin Graham, the father of value investing, summed it up this way: "In the short run, the market is a voting machine, but in the long run, it is a weighing machine." The trick is figuring out exactly when and how Graham's voting machine will get turned off and his weighing machine turned on.

And in truth, there are no crystal balls -- no ways of knowing with certainty when the market's weighing machine will realize that its voting machine threw the wrong candidate to the curb in disgust. If we want to beat the market as value investors, we must accept that reality. We must accept the fact that we can't know when a company's market price will cross its true value, just that the two eventually will cross.

Been there, done that
For example, literally hours after I purchased homebuilder Lennar (NYSE:LEN) (NYSE:LENb) last October, I had lost some 4.5% of my investment. Later that same month, my loss had more than doubled to about 10.6% of my investment. And now, just less than a year later, Lennar's business is still going strong, and its stock has been added to the S&P 500 index. Its shares have recovered and handily beaten that index even for those of us who didn't happen to buy in at the bottom. Thanks to that recovery, its stock price now much more closely approximates the company's true worth than it did last year, and those of us who put up with the short-term pain have earned a longer-term gain.

Similarly, I found credit-scoring giant Fair Isaac (NYSE:FIC) to be an irresistible purchase in June 2004, just before it announced that its business would be weaker than expected. Predictably, the bottom immediately fell out from what I thought was already a bargain-priced company. It, too, has since rebounded to become a market-beating investment, one I would not have realized had I not been willing to wait through the rough spots.

Why bother?
We simply can't tell when the market's switchover from voting machine to weighing machine for any particular company will happen until after the fact. And by that point, of course, it's too late to buy in before the switch. So if we want to profit from that voting machine's mistaken pricing, we must simply buy and wait. Buy a company while it's on sale, then wait for its market price to recover. When exactly the sale will end, nobody knows. But when it's over, the results can be spectacular.

My friend and colleague Philip Durell runs Motley Fool Inside Value. The results from his scorecard perfectly illustrate how value investing often works in practice.

As you can see, companies selected recently have been underperforming the index. The farther back in time you go, however, the better Inside Value's picks have done. In the short term, the market's voting machine has thrown out and continues to throw out companies because of temporary issues. In the long run, however, the market eventually wakes up to the true weight of value-priced companies and boosts their stocks accordingly.

The Foolish bottom line
When companies go on sale, there tends to be a reason, such as an expected bad future business climate, an accounting scandal, or significant and unforeseen product liabilities. As a value investor, if you can tell the difference between a problem that will sink a company and one from which the business will likely recover, you can profit from the bad news. To do so, however, you must be willing to wait. It just may be the most difficult -- and the most rewarding -- part of investing.

Do you have what it takes to sit and watch grass grow? Are you willing to wait for companies you own to fix their problems before providing you with a reward for your patience? If so, then Inside Value is for you. Click here to take a risk-free 30-day trial or to join and learn where else the market's weighing machine may soon need to respond.

At the time of publication, Fool contributor and Inside Value team memberChuck Salettaowned shares of Lennar, Merck, and Fair Isaac. Fannie Mae and Pfizer are Inside Value recommendations. Merck is a Motley Fool Income Investor recommendation. The Fool has adisclosure policy.