Hedge fund advisor John Mauldin recently said, "Based on 2008 as-reported earnings, the S&P 500, which closed at 735 today, has a trailing P/E of 52. ... Caution is the word today."
Two days earlier, professor Jeremy Siegel went on record in The Wall Street Journal saying, "If one applies market weights to each firm's earnings using the same procedure that S&P employs to compute returns, the results yield ... a P/E ratio of about 9.4." He went on to add, "When computed accurately, P/E ratios show that this market is much cheaper than is currently being reported by the S&P. Those who venture into today's stock market are indeed buying good values."
I don't know about you, but every time I hear a pundit argue that "the market's overvalued" or "the market's oversold," I shake my head in disbelief. How anyone can accurately gauge the value of all 10,000-plus companies composing "the market," and conclude that they are "expensive" or "cheap" is beyond me.
Maybe it's because they're Wall Street Wise Men and I'm a simple Fool, but I find it difficult to value more than one company at a time. With an individual company, I can look up its market cap and calculate its growth rate. I can count the cash in its bank account and match that up against debt on the balance sheet. I can listen to the CEO speak on the conference calls and decide "this gentleman sounds honest " or "that lady's selling snake oil."
But the whole market? Why, the market doesn't even have a CEO.
Market, shmarket
Honestly, though, it doesn't matter -- because I don't invest in "the market." While it's true that a broad-market index fund is better than buying a basket of so-so companies, I prefer to pick and choose only the very best companies. It's the only way to beat the market -- whatever it's worth.
So how do you find the "very best" companies? In grade school we called it "wandering eyes." At the Fool, we call it "studying the masters" -- imitating the successful strategies devised by those who've come before us, and tweaking and improving upon them to suit our own style.
"Buy what you know"
Investing legend Peter Lynch, former manager of the Fidelity Magellan Fund, earned 29% annual returns during his tenure from 1978 to 1990. One of his most famous tenets is that some of your best investment prospects lie in companies you already know, whose stores you shop, whose products you use every day. Why research an unfamiliar company when you can research one you already have firsthand knowledge of?
Following this logic, Lynch bought stocks like Toys "R" Us, which ultimately made him a multimillionaire. But it works on a smaller scale, too. Over the years, I've rung up profits by "following the money" on my wife's credit card bills. Nokia (NYSE:NOK), priceline.com (NASDAQ:PCLN), Dress Barn (NASDAQ:DBRN) are all picks inspired by personal experience.
Seek out hidden value
Some companies have so many moving parts as to defy easy analysis. Take homebuilders for example. No one's arguing Pulte (NYSE:PHM) and Toll Brothers (NYSE:TOL) aren't worth something. But with government housing policy changing by the day, and every quarter bringing new writedowns of property holdings, Wall Street's having the devil's own time putting a number to that "something."
True value doesn't remain hidden forever. Legendary economist Eugene Fama may have overstated the case when he developed his "efficient market" theory. But given time, Wall Street will ultimately figure out what these companies are worth. Our task as investors is to beat Wall Street to the punch. Where few are certain of a company's true worth, there lies opportunity.
When stocks are out of favor, we can figure out if they're out of favor for a good reason (i.e., if they're value traps) or if they're really selling at a discount to their true worth. I suspect this is keeping Warren Buffett pretty busy these days.
Profit from panic
Speaking of Buffett, you're probably all familiar with this line from the Oracle of Omaha: "We simply attempt to be fearful when others are greedy and to be greedy when others are fearful."
For the past several months, we've been treated to heaping helpings of both greed and fear. Once upon a time, a 3% move on the Dow was headline news, but it seems lately that the market makes multipercentage-point moves several times a week.
While headline writers might rub their hands with glee over such volatility and the chance to use their secret dictionary of scary and superlative words, the issue is more important than that. If you're an institutional money manager getting your quarterly performance reviewed every three months, such short-term volatility has to be terrifying, because you're judged on that short-term performance.
As individual investors, however, we're our own bosses. No one's going to fire you for buying an unpopular stock -- no matter what happens in the short term.
Sure, the spouse and neighbors may chuckle at your Foolishness, but heck, laughter rocked Wall Street when word got out that Buffett was buying SunTrust and Bank of America (NYSE:BAC) a few months back, and GE more recently. But do you want to bet against the Oracle of Omaha?
Foolish takeaway
When you get right down to it, that's the real question. Are you going to let the talking heads on Wall Street and its environs sway your investing decisions with their "random talk" of overvalued and undervalued "markets"? Or are you going to imitate the great investors -- Buffett, Lynch, Shelby Davis, and others -- by digging into individual companies and digging up the companies that are undervalued in any market?
At Motley Fool Inside Value, we humbly suggest the latter. From our very first investment -- a counterintuitive pick of scandal-tarred MCI that earned our subscribers an incredible 57.5%, including dividends, when Verizon (NYSE:VZ) bought it only a few months later -- through the market-beating investments we're still making today, we've practiced what the masters preach. If you'd like to join us in the quest for hidden value, take a free trial today. Just click here to get started.
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This article is adapted from "Buy When Wall Street Won't," which was originally published Feb. 8, 2005.
Fool contributor Rich Smith owns shares of Nokia, priceline.com, and Dress Barn. priceline.com is a Motley Fool Stock Advisor recommendation. Nokia is an Inside Value choice. The value of The Motley Fool's disclosure policy is hard to overestimate.
