Pass the Tums, honey?
It's hard to be a value investor nowadays. Being a value investor often requires the intestinal fortitude to go against the dominant market wisdom of the day and the emotional strength to withstand the self-doubt that creeps in when an investment doesn't go the right way immediately. People who want to be successful value investors often seek to emulate the greats -- Warren Buffett and Charlie Munger of Berkshire Hathaway, Philip Fisher, Joel Greenblatt, Bill Miller, Marty Whitman, and many others. Many books have been written about their value-investing strategies and just how they pick that perfect company, while making a considerable sum of money off a single purchase. So, what do budding value investors need to begin their search for the perfect company?
Well, there's one common character trait that all these famous investors share. One of the key traits a successful value investor must have is a variant perception. This basically means an investor holds a strong viewpoint that is substantially different from what the market viewpoint holds. Whitney Tilson put it well in a Fool article a few years back when he asked the question, "What, exactly, is it that I understand or believe about this company that differs from the consensus view?"
If we can answer Whitney's question with "Everything!" or at least "Something," then perhaps we have a good prospect to begin due diligence on. When Bill Miller was purchasing Google (NASDAQ:GOOG) during and shortly after it came public at $85 a share, you'd better believe he had a variant perspective on the company, as many analysts and market observers pooh-poohed the company on account of some rather large public scandals at the time. The market perception then was decidedly negative for several reasons: (1) an SEC investigation after the founders gave a Playboy interview in their "quiet period" before the IPO, (2) the violation of federal securities laws by illegally issuing more than 28 million shares of Google stock and failing to register them properly, and (3) a major PR issue by the mishandling of the launch of Gmail, and the resulting privacy issues from handling of customer information.
This forced the company to revise its Dutch auction price down from the $120 to $130 range to a lowly $85. Well, Bill wasn't fooled, because he understood that once the market realized the earning power of the business model and how it had underestimated the disruptive potential of its AdSense technology to the traditional online advertising model, the stock was going to be worth a bit more than $85 a stub. And he was right -- the stock trades around $360 today, nearly two years later.
Geez, you sure know how to rub it in, don't ya?
The key thing to understand is that betting against the market consensus can be extremely lucrative if you're right -- and it's hard to be right consistently. After all, the market is usually correct in most short-term situations but is often nearsighted when it comes to long-term expectations. This opens a world of opportunity for the value investor. To effectively take a position against the market consensus, we need to not only understand the business fundamentals and how deeply undervalued the company is, but we need to also understand the market perception of the company. In my mind, this is one thing that budding value investors often overlook, and therein lies their biggest mistake.
By failing to understand how the market perceives the company, investors often grow frustrated when the stock fails to move up in immediate fashion. After all, doesn't the silly company know that I, the esteemed investor, now own the stock? Sheesh, the ignorance of some companies! So investors sell the company and move on, only to watch the stock double later, as their investment thesis is accurately realized. Oops ...
So it's bad enough I missed Google, but now I've missed the next big thing, too?
Think about it. It's easy to invest with the market herd right now. Just go out and buy some shares of Wall Street's favorite highflier and see what the party is all about. Unfortunately, those stocks are priced in such a way that the rosy outlook for the next few years, at least, is accepted as a given. And at this point, an investor is unlikely to make much, if any, money. You're paying a hefty price for consensus and a future that the market is certain will be outstanding. The greatest risks actually lie in buying into a company when everyone agrees that it's a sure thing.
Ouch -- now I REALLY need those Tums
Here are some guidelines on finding a potentially winning stock:
- Understand the business prospects of the company.
- Price out the company's intrinsic value and compare it to the current stock price.
- Identify the market perception of the company.
- Identify your variant perception, if any.
- Search for catalysts that might encourage the market consensus to change.
The key is to understand the market perception of the stock before buying, identify what needs to happen for that market perception to change, and, on some level, determine the probability of this expectation coming to fruition. Identify that probability trigger point (to the extent that a defining "trigger point" exists, because it's sometimes much more subtle) and the associated likelihood of its occurrence, so that you can assess the company's prospects in a given sequence of events. If you understand the trigger points and why the market is treating the company the way it is, then it's easier to hold through thick and thin.
In fairness, when or if the market comes to realize your perception, it bears mentioning that this isn't necessarily a sell or buy signal. Instead, consider this an opportunity to reevaluate the company's intrinsic value and prospects relative to the market perception of the company. If the margin of safety is too small for comfort, or if Wall Street seems to be getting unduly optimistic, it might well be time to take some off the table. By taking the long-term approach, investors can afford to outwait their formerly impatient selves. In an ideal-case situation, investors will likely find themselves holding more winners instead of selling them at just the wrong time.
And amazingly enough, we have an entire team of people with highly honed variant perceptions, who identify great opportunities 24/7/365. At Motley Fool Inside Value, lead analyst Philip Durell is generously offering a free 30-day trial to anyone who wants to sign up.
Stephen Ellis welcomes your feedback at [email protected]. He owns none of the stocks in this article, not even Google (sigh!). The Motley Fool has a variant perception too, with its ironclad disclosure policy.
