Wall Street's conventional wisdom gets only half the story. In their world, growth is prized over value, based on the theory that the potential of $2 tomorrow is worth investing $1 today. What they neglect to recognize, however, is that if you can buy some of those genuine $1 bills for $0.50 each, you may end up with an even larger gain, for a lot lower risk of catastrophic failure.
While value investors understand that projections for the future and for growth are what largely drive a company's true worth, we won't buy shares in a company unless it's trading well below where it really should be today. In essence, we're looking to buy companies that should be worth $2 tomorrow for $0.50 today.
Search the trash heap
Here's how we do it. We know that value-priced companies have an advantage over the rest of the market. Their advantage is simple: They're expected to screw up. They've been beaten down, knocked out, and left for dead, and the market's predictions surrounding their future are dismal at best. So how, exactly, is that an advantage? When the market's expectations are that low, all a company has to do is not screw up in order to beat them.
Think about that for a moment. What's easier to do -- the bare minimum that is necessary to scrape by, or going all out for the chance of wildly exceeding your original plan? Doing the bare minimum, of course. In the short run, companies are mostly judged based on how well they do when compared with how they're expected to do. So if a firm that's expected to keel over merely manages to keep going, that's usually a bigger win than the old Wall Street standby of beating expectations by a penny.
Take Sears Holdings (NASDAQ:SHLD), for instance, which traces its roots to a merger between two suffering retailers: the formerly bankrupt Kmart and the long-suffering Sears. Individually, neither company had much recent success. Kmart was largely forced into bankruptcy because it couldn't match Wal-Mart's (NYSE:WMT) efficiency or prices. Sears, on the other hand, had never quite learned how to thrive following the demise of its catalog business, spent way too long trying to appeal to "the softer side," and managed to cede much of its core appliance market to home-improvement giants like Motley Fool Inside Value selection Home Depot (NYSE:HD).
Billionaire hedge fund manager Eddie Lampert bought Kmart out of bankruptcy. He then sold off underperforming stores in appreciated neighborhoods, which unlocked tons of cash that had been trapped in the company's bricks and mortar. Lampert was so successful with that strategy that Kmart's stock skyrocketed high enough for it to be a useful currency in acquiring Sears. Together, they're still not that great as retailers, but because the expectations were so low, the company couldn't help but beat them. This chart shows just how far the stock has risen, and just how well an investor can do by buying when things look the worst.
At Inside Value, lead analyst Philip Durell took advantage of a similar situation with bankruptcy survivor MCI. The parallels were uncanny. Just like Kmart, MCI had recently emerged from bankruptcy and was still viewed as a weakened player in an extremely competitive business. Its traditional long-distance network was fast becoming a dying breed, thanks to virtually free IP telephony from the likes of eBay's (NASDAQ:EBAY) Skype service and bundled long distance from cell providers like Sprint Nextel (NYSE:S). Yet even as a weak player in a dying industry, MCI had a legitimate value, and its shares were simply trading well below that level.
Your booster rocket
Every company has a fair value -- a price that represents what its underlying business is really worth. That number changes over time as the business itself matures. A growing company may very well see its fair value rise for as long as it keeps growing. In the absence of radical business changes, that value doesn't tend to drastically change. Over long periods of time, the company's market price tends to find its true value, though sometimes the price is too high, and sometimes the price is too low. If you buy in when the price is too low, your portfolio gets an extra boost. After all, since price eventually reaches value, the shares you bought too low will get an additional lift to that level, in addition to any true value growth that may occur.
Ask yourself a few questions: Is the air-conditioning business really 62% better than it was in March 2004? If not, then why has my position in Lennox International (NYSE:LII) grown that much in that time? Could it be that the company has simply recovered to an accurate value now that its inventory scandal is behind it? Has the tax-prep and small-business-accounting market really grown 40% in the past year? Then why has Inside Value pick Intuit (NASDAQ:INTU) jumped that much that quickly? It's likely because the market's fear that it would be trampled into oblivion by larger and better-capitalized rivals proved to be unfounded.
The Foolish bottom line
Successful business certainly can grow over time, taking their stocks along for the ride. You can get ahead of the curve with your portfolio, however, if you look for firms that happen to be trading well below where they should be.
Are you ready to start looking for companies trading cheaply enough to jump-start your portfolio? Click here to begin your 30-day free trial to Inside Value and learn how to find them. Subscribe today and you'll receive Stocks 2006, the Fool's guide to the investing year ahead, absolutely free.
At the time of publication, Fool contributor and Inside Value team memberChuck Salettaowned shares of Lennox International. eBay is a Motley Fool Stock Advisor recommendation. The Fool has adisclosure policy.
