Let's start out with a pop quiz! Over the past year, "The Market" is:
As of today, over the past year, the Nasdaq Composite and the S&P 500 are up about 5%, with the Dow treading water just above flat. And because the start and end points are within a few percentage points of each other, we hear endless talk about what a tough market it is to make dough. How can anyone possibly profit when "the markets are flat"?
The truth is, the markets are not flat. Almost never. There are always wiggles. Which is why the correct answer to our pop quiz is (D.) all of the above. As you can see, if you'd bought the indexes at their lows and held until today, or sold, you'd be sitting on some nice gains, even though things come out looking flat overall.
And even if The Market is flattish, this says nothing about the turns in the individual stocks that comprise it. Flat markets = flat stocks? Of course not. Just ask holders of Research In Motion
How's your crystal ball?
Well, if there are lows and highs, there's money to be made, right? Buy low, sell high? Oldest trick in the book! We can all learn to do that, right?
That's a promise I hear all the time, often during a Sunday afternoon trading-software infomercial hosted by some dude with a zany, down-under accent. But attempts to do this based on charts or astrology -- I swear I met a guy who programmed trading software that did just that -- are fantasy.
But that zany guy and I agree on a couple of things. There are wiggles, and the wiggles do give you opportunities for consistent profits. But not by betting on some formation of squiggles, cup-and-pinky formations, or market momentum. This kind of "investing," devoid of fundamentals, is what leads to the infamous middle-finger chart provided by the likes of JDS Uniphase. And we all agree that we want to avoid that.
Making money during flat markets
There are a few simple steps that I, along with my colleagues at Motley Fool Inside Value, all follow to find profits from the strong, sometimes violent currents beneath the deceptively smooth surface of the market.
- We forget about The Market.
- We look at individual companies.
- We cash in on those wiggles whose risks and potential we can quantify.
It really is that easy.
Forget the market
Why should you forget about The Market? Because you can't put a proper price tag on it. Want to give it a try? Good luck.
How about polishing off the old chestnut, the market P/E? What market? Whose price? What earnings? With companies like Salesforce.com
Should we take a stab at valuing The Market's future cash flows? The Market's brand power? The Market's competitive moat? The Market's new turnaround CEO?
You should be giggling or rolling your eyes by now; you can't do any of these things for a basket of 30, 500, or 3,000 companies. And since you can't apply valuation tools to The Market, you can't possibly know if you're buying right. All you can do is pay up and hope. That's not investing, and it's a great way to make sure that you never hit the right part of the wiggle and therefore suffer the inevitable fate of the flat markets.
It's a completely different story when you tune in to individual companies. When we turn our value methodology toward a firm, we're looking for things we can measure. Which direction are sales headed? How much of that money on the top line filters down to shareholders? Will this brand be around in a few years? Ten years? Twenty? Can we make a reasonable estimate of what future earnings growth will look like? The final, most important step is this: What's the present value of that future growth, and can I buy for less than that price?
An example of a company that is fairly simple to understand and value, if you just peek beneath the hood, is an Inside Value pick that also happens to be a household name. It's also a firm I recommended in last summer's Motley Fool Blue Chip Report: a little outfit called Microsoft
Microsoft might seem complex, but underneath all those operating systems, is a company that does some pretty simple things. It sells stuff for a lot more than it costs to make it. It is also a company that has a more-than-stable footprint in its market, stable margins, copious free cash flow, and its long-term returns on equity -- in the 20% range -- strongly suggest that it will keep on churning out improved earnings.
With a bit of focus, I could strain out a few of the extraneous items from the past few years' earnings, and it was easy for me to see that Microsoft was healthier than commonly assumed. I pegged the current value of the shares at about $33 each, for a pretty hefty discount to today's prices.
Frequent value with the bigger wigglers
Microsoft may be an example of an undervalued giant, but its long, slow stock slide doesn't show the kind of wiggles I usually look for in values. On Microsoft's turf, I continue to be entranced by the lack of enthusiasm this year for shares of Dell
But for nonstop bargain opportunities, I tend to shop retail. I like hunting for value in retail because it is a space where even proven leaders are victimized by the market's short-term concerns. In other words, the wiggles here are bigger and more frequent, meaning potential values on a monthly basis.
Take a company that recently hit value turf in my opinion. Abercrombie & Fitch is the leading clothing retailer in one of the most lucrative demographics in the industry -- teenagers with money.
It has suffered some sales bumps, but when I first recommended it to Fool subscribers as part of our Halloween special in 2004, it was sitting on a boatload of cash, had begun turning sales around, and was producing a lot of free cash flow. It didn't disappoint me, turning in a 35% gain in one year.
This past Halloween, after another big downward wiggle, I thought the shares were still significantly undervalued, trading around $50 each. Based on a simplified discounted cash flow analysis, I figured they were worth closer to $65 each. So I went to the well again. I only wish I'd followed my own advice and bought shares myself, as they're up a strong 25% since then. (By the way, Inside Value subscribers can perform their own DCF calculations with our handy tool.)
For what it's worth, I think Abercrombie is no longer in value territory, but investors might turn their attention to its downmarket peer, Aeropostale
The Foolish bottom line
Don't let anyone fool you (with the little f) about the futility of "flat markets." There's always something moving. But the only real way to capitalize on the underlying volatility in individual stocks is to buy them when they're selling for your estimate of what they're really worth. Luckily for us, this happens with great frequency.
(And by the way, I just noticed that one of this month's Inside Value picks just happens to come from my favorite field -- retail duds. It's a company I had sort of written off, but hey, I've learned not to bet against my colleagues. If you want to see if you're convinced, a free trial is just a click away.)
For related Foolishness:
- At Microsoft, no more call waiting.
- Wiggly stocks too scary? Try a lazier approach.
- Learn more about how to double your money.
Seth Jayson is constantly on the lookout for other people's junk. At the time of publication, he owned shares of Microsoft and Aeropostale but held no positions in any other firm mentioned. View his stock holdings and Fool profile here . Dell and TiVo are Stock Advisor recommendations. Fool rules are here .