When the average investor hears the term "value investing," the first thoughts that spring to mind may be of asset plays, single-digit P/E ratios, and paying 40 cents on the dollar for the most boring company you can find.
Allow me to offer a broader view of the concept. Value investing simply means "investing for value," which also includes paying less than the full premium for a premium stock. Getting value on that premium is the subject of today's discussion.
What is premium value?
Recall our recent discussion on the value of pocket aces in No-Limit Texas Hold'em. In that hypothetical scenario, you and two friends each bet $100 all-in before the flop. For fun, your friends let you play any two cards from the deck, with the stipulation that you must pay a premium for it. We know that pocket aces (A-A) will win more than its fair share (33% of the money) against any two other hands, and so this hand is always worth a premium (more than the $100 initial bet) in this scenario. Given further review, we concluded that the value of the premium was probably in the neighborhood of $99.51 and $113.87, and almost certainly more than $73.17.
Think about what that means:
The average poker hand, pitted against any two random hands, will be worth exactly the $100 we put into the pot -- and not a penny more. And pocket A-A -- the best-in-class hand -- is worth at least $173.17, a premium of $73.17, or 36.6% over the average hand. That said, if you could pay an average price ($100) for a premium hand (worth at least $173.17), then of course you would do it. In fact, you are almost certainly getting value at any price under $173.17.
Similarly, the average stock will, on average, match the market performance. And if you could buy a share of a company worth a premium multiple to earnings -- such as a Google (NASDAQ:GOOG) or an eBay (NASDAQ:EBAY) -- but only pay the market average multiple for it, then you have come across a highly favorable situation.
What characteristics warrant premium value?
In general, you are looking for the best player in an increasingly relevant industry. Companies with strong, durable competitive advantages tend to generate higher returns on invested capital than their peers, and they feature both higher-than-average growth rates and outsized market share. Moreover, having a dominant competitive advantage lessens business risk.
For example, top video game publisher Electronic Arts (NASDAQ:ERTS) -- which has dominating market share in the sports video game segment (75% in its fiscal second quarter) -- is, in my humble opinion, worth a premium to smaller rivals like Activision (NASDAQ:ATVI) and Take-Two Interactive (NASDAQ:TTWO). Similarly, eBay dominates the online auction and payments markets, Expedia (NASDAQ:EXPE) controls 40% of the online travel agency market, and slot king International Game Technology (NYSE:IGT) is responsible for two-thirds of the domestic slot market.
The advantage in owning premium stocks
If the debate is between buying a good company at a great price and buying a great company at a good price, my preference is to go with the great company. Where a value investor may take on a mediocre business at a value price, most of the time the plan is to sell it when the stock approaches full value. However, that investor must also pay capital gains taxes, which is a handicap on future performance. The advantage in purchasing a great company is that it is a stock that you will actually want to own for the long haul.
Remember: The money you save is worth every bit as much as the money you earn.
Wait for the fat pitch and hit it hard
Investors have a great advantage unavailable to poker players: An investor can wait almost indefinitely for the fat pitch.
You see, in any poker game, the speed of the game is determined by forced bets called blinds and antes. In Hold'em, there are generally two forced blinds in every hand. Unfortunately, if you were to sit around and only play pocket A-A, you would eventually go broke, as you only get dealt A-A once every 221 hands. At a full 10-person table, you would get dealt A-A once every 22 rounds, so in a game with $5 and $10 blinds it would cost you $330 just to wait. However, by the time A-A does come, you will never get any action from the other players, and thus would never recover the $330 you spent to get there. Thus, in poker, you must play lesser hands.
But as an investor, you can afford to wait. You don't have to lessen your requirements. Opportunities to buy great companies at good prices occur with some frequency, particularly when the market has dogged a company or an entire industry over short-term concerns, despite long-term promise. I think both Electronic Arts and Expedia fit in this category at the moment, as did IGT just a few months ago.
Just stick to the best players, wait for the right price, and be ready to pounce when that opportunity knocks.
Electronic Arts, eBay, and Activision are Motley Fool Stock Advisor picks.
Every month, the Fool's Inside Value newsletter service hunts for out-of-favor value (out-of-favor turnaround plays) and relentlessly growing values (premium value). If you'd like full access to the team's entire list of buy reports, click here to try the service free for 30 days.
Fool contributor Jeff Hwang owns shares of eBay, Electronic Arts, Activision, Expedia, and International Game Technology. The Fool has a disclosure policy.
