There's a street in New York City where well-dressed men and women go to give away money every weekday. Cries go out: "Hey, buddy, I'll give you three tens for that twenty," or "Can you break a fifty? Give me two twenties, and we'll call it even." Believe it or not, these are people with college or even graduate-level educations, and they're making bad deals on a regular basis. The place is Wall Street, and the venue is the stock market.
You can work the system
On Wall Street, when news is good, it is very, very good; when it's bad, it's horrendous. And when bad news hits, shareholders can be heard saying, "Give me two twenties, and I'll give you this fifty," often selling companies at significant discounts to their fair value.
Obviously, being on the right side of such deals can be enormously profitable. Many of the greatest investors have made a fortune doing exactly this. I've studied these investors for years -- legends such as Warren Buffett, John Neff, and Bill Miller. They all seem to share three primary characteristics:
Just understanding these three traits can make you a much better investor. With those qualities firmly in place, you can profit from the market's mispricing.
Seeing what others can't
When my colleague Philip Durell first brought up money market fund provider Federated Investors
Imagine my reaction, then, when he recommended Federated in his Motley Fool Inside Value newsletter service. Admittedly, the company's shares were trading well below their fair value at the time. Still, I was surprised he would pick such a downtrodden, unloved company. The stock market obviously shared my concern that Federated was facing tremendous difficulties.
At $28.87 in March of this year, Philip made a compelling argument that Federated was worth buying anyway, despite the market's uneasiness. His argument was that with short-term interest rates rising, Federated's business would be improving. Sure enough, just a few months later, Federated's stock has come rocketing back.
Great Value Investor Trait No. 1: Objectivity.
Staying when others jump
Of course, the stock market is a very volatile place, especially in the short run. Very shortly after I bought a stake in credit scoring giant Fair Isaac
Anyone willing to read beyond the headline and delve into the business could have clearly seen that Fair Isaac would easily survive its short-term crisis. Not only has it survived, but what had been a 30% loss turned into a nearly 30% gain. For me, this market-trouncing gain came simply because I was confident in the strength of Fair Isaac's core business, in spite of its weak short-term stock movements and near-term outlook.
Great Value Investor Trait No. 2: Confidence.
Doing the time
Of course, for a company to be trading well below its real worth and thus be appealing to value investors, there usually has to be something wrong with it. Take Inside Value selection Fannie Mae
Until Fannie Mae gets its books straightened out and Congress goes back to worrying about other things, its stock will likely remain depressed. Unfortunately, nobody quite knows exactly when all the loose ends will be tied up. Once things are repaired, however, the market will likely react far quicker than you or I can. As a result, current investors wishing to profit from Fannie's current problems will need to wait patiently for the company to emerge and the clouds to be lifted from its future.
Great Value Investor Trait No. 3: Patience.
Putting it all together
To make money as a value investor, you need to be able to take advantage of Wall Street's emotional roller coaster. Buy those $50 bills when the market thinks they're only worth two twenties. Then, turn around and sell when that same stock market offers you three tens for each of your twenties. If you think you have the right mix of objectivity, confidence, and patience to beat the market, you can join Philip Durell and the rest of the Inside Value crew on the quest to stay ahead of the very same market he has easily trounced.
Not quite sure if you've got the ability to beat Wall Street at its own game? Click here to start a 30-day free, no-obligation trial to Inside Value. Go ahead, kick the tires and find out whether value investing is the right way for you to beat the market. Or,subscribetoday and receive Stocks 2006, the Fool's guide to investing in the year ahead, absolutely free.
This commentary was originally published on Dec. 29, 2004. It has been updated.