To me, "value investing" is a repetitive term. What is investing, if not the search for businesses offering value? Still, many investors miss the point of value investing entirely -- because they fail to spot the one factor that defines every great investment.
Not all value stocks boast low price-to-earnings (P/E) multiples. And companies with low P/E ratios are not necessarily value stocks. It's true that in the long run, the odds suggest that companies sporting lower earnings multiples should perform better over time. But simply buying a company selling at less than 10 times earnings is not value investing.
What makes a company today worth much more tomorrow is the presence of a catalyst -- an event that unlocks value. The list of potential catalysts can be exhaustive, so let's stick to three examples that are easier to spot than others.
When all else fails, a troubled company usually must replace current management, and a fresh hire can sometimes unlock value. Under CEO Carly Fiorina's watch, Hewlett-Packard
Amid the current credit turmoil, the CEOs of Merrill Lynch
In the late '80s, the video-rental business was just getting started. At that time, most video rental operations were locally owned dives, and Wayne Huizenga was running a small video chain by the name of Blockbuster. Convinced that the video rental market was in its infancy, he embarked on a breathtaking expansion of Blockbuster stores. By 1994, when Huizenga sold the company for $8.4 billion, Blockbuster had more than 3,700 stores. From an idea to more than $8 billion in less than a decade? Now that's a new market! (This amazing story can be found in The Making of a Blockbuster by Gail DeGeorge, an inspiring account of Blockbuster's success under Huizenga.)
Recently, Warren Buffett disclosed a sizable stake in railroad operator Burlington Northern Sante Fe
Apparently, Buffett feels that for the first time in a long time, the railroad industry's fundamentals are improving. Thanks to the commodity boom in China and India, railroads are operating at full capacity. In addition, technological innovations like double-stacked railcars provide greater efficiency per mile. In short, railroads are beginning to generate returns above their cost of capital. Given Buffett's long-term view, Berkshire Hathaway's
Value or value trap?
The creation of value defines a successful investment. That value can come in many shapes and sizes, but a good investment will always unlock it. Identifying catalysts like the three above will help you determine which companies are likely to unlock their value, and which will remain locked down.
For more bargain-hunting:
Fool contributor Sham Gad is managing partner of the Gad Partners Funds, a value-focused concentrated investment partnership based after the 1950s Buffett Partnerships. He has no stakes in the securities mentioned. The Motley Fool holds stock in Berkshire Hathaway. The Fool has a well-defined and beautifully articulated disclosure policy.