When you hear the term "value investor," what comes to mind? If you're like many folks, you probably think of stodgy old men who are worried primarily about holding on to what they've got, rather than about seeing their money grow. In truth, that impression couldn't be more wrong. Typical value investors:
- Invest for the long haul.
- Seek to beat the market.
- Actively buy the companies that Wall Street mistakenly views as the most risky.
To the extent that successful value investors such as Warren Buffett and Charles Munger always seem old, it's because value investing has been shown to work consistently over time. You don't hear much about successful 80-year-old momentum traders, do you? That's because momentum tends to work until it doesn't. At that point, it fails spectacularly. Wild fortunes are won, then lost, in the momentum game, and eventually everyone's luck runs out.
Value investing, on the other hand, takes a few straightforward concepts and uses them as a solid and reliable framework for making investing decisions. The value framework has stood the test of time, and generations of investors have profited from it. Better yet, it still works today -- and it could have helped you more than quintuple your money as recently as six years ago (but more on that later).
Laying a foundation
If you want to receive the benefits of the value strategy, you must first understand how it works. There are three key points to keep in mind:
- A stock is nothing more than a partial ownership claim on a business.
- A stock's true value is based on the cash-generating capacity of the underlying business.
- Eventually, a company's market price will reflect its true value.
Those simple statements form the core of the value philosophy. When other investors forget those truths, the market creates opportunities for those who remember. And that's where value investors like those of us at Motley Fool Inside Value get our edge.
Value investing in practice
Time and time again, the results of forgetting those core tenets of investing have been disastrous. In March 2000, for instance, networking titan Cisco Systems
Now as for the five-bagger I mentioned earlier, about the same time Cisco was trading in nosebleed territory, mall operator General Growth Properties
What happened?
In the late 1990s, technology spending shot through the roof. This was largely driven by the need to update every bit of infrastructure and every application to be Y2K compliant. That spending binge directly and dramatically benefited companies like Cisco, which could only promise Y2K compliance on its newer systems. At the same time, new Internet-enabled sales channels such as Amazon.com
Add together the effects of the tech spending splurge and the potential for Internet-based retail disruption, and the result was a market that lost focus on reality. Instead of being based on actual delivered cash flow, many market valuations were based almost entirely on what might happen. Remote possibilities were being priced as near certainties. As a result, the market dramatically overpriced many technology stocks while simultaneously pricing bricks-and-mortar businesses as if they were already dead.
Focus on the cash
Of course, nobody can predict the future. While hindsight makes it easy to determine what happened, actually living and investing through the insanity was something else entirely. The truth is that we can't know ahead of time what'll really happen. What we can do, though, is tilt the odds in our favor by focusing on the cash generated by a stock's underlying business, just as successful investors have done for decades.
To get a decent handle on what a company is really worth, you can start plugging in numbers to a discounted cash flow calculator, like the one we have available here for Inside Value subscribers. (A free trial, available here, will get you access.) By adjusting the assumptions in the calculator so that the answer it delivers matches the current market price for a company, you can estimate what the market expects. With that information in hand, your job becomes simply to evaluate whether the market's assumptions seem reasonable.
Put it to practice
For instance, running through that exercise for Inside Value pick Coca-Cola
That discount is your opportunity to profit. If the company delivers sustained 6% growth or better, your total return will include a bonus, on top of the benefits you get from the company's dividends, buybacks, and the gain from its growth over time.
History repeats itself
For generations, value investors have crushed the market by making such comparisons between the market's expectations and the cash delivered by the company's results. With Inside Value helping you master the value framework, you can join the next class of folks who've tamed Wall Street. The July issue releases today at 4 p.m. ET. Click here to access today's two new stock recommendations with a 30-day free trial.
At the time of publication, Fool contributor and Inside Value team memberChuck Salettahad no direct ownership of any company mentioned in this article, though his wife owned shares of General Growth Properties. eBay and Amazon.com are Stock Advisor recommendations. The Fool has adisclosure policy.
