Why Didn't You Bag These Returns?

The idea that anyone can precisely time the crazy movements of the stock market seems ludicrous to me. Yet in recent months I've been talking a heck of a lot like a dyed-in-the-wool market timer.

Like most everyone else, I've been mesmerized by the stock market's run since last year's bottom. As a result, I've done a lot of talking about the incredible returns that many stocks have delivered since the market's nadir in early March of last year.

Source: Yahoo! Finance.
Stock returns from 3/9/2009 to 4/23/2010.

Some of these may seem like obvious picks in retrospect. Ford, for instance, may still have a gnarly balance sheet, but the company has been able to take advantage of its competitors' tough times and has not only taken market share, but started to turn a profit again. As for American Express, the 16% year-over-year gain in cardholder spending and 135% jump in earnings per share that the company revealed in its first-quarter report seem to show that it's still the high-quality credit card operator that it's always been.

But all of this wasn't terribly obvious a year ago, and to bag the returns in the chart, you not only had to shrug off the very real concerns that either of these companies could get chewed up and spit out by the recession, but you also had to invest right on March 9.

Suggesting that it was possible to time the market and pick up these stocks right at the bottom is silly. As far as I'm concerned, definitively making that call would have been impossible for anyone short of Miss Cleo.

The timing conundrum
Yet the urge to try and figure out what the market is going to do next continues to draw investors like a sweet siren's song.

Trying to time the market can be downright ulcer-inducing, though. Take Capital One's (NYSE: COF) stock for instance. Between October 2007 and March 2009, I counted at least four instances of the stock having runs of 20% or more -- including a jump of more than 50% between July and September 2008. If you had taken any of those rallies as a sign that Capital One's stock was ready to rock and roll, you would have been in for a nasty surprise.

And if you're trying to time the stock today, how can you be sure that the 400% gain it's seen since early March of last year is going to hold up? The finance industry has had quite a turnaround and consumers are showing a little more life, both of which are good signs for Capital One, but when it comes to the unpredictable Mr. Market, it's still a guessing game as to where the stock will end up tomorrow or next week.

As long as you're trying to guess what the market is going to do next, it seems like inevitably you're either going to end up jumping in during a "sucker's rally" or be so cautious that you miss out on gains once the market's heading up.

But it's a whole different ballgame if, instead of watching the market's movements, you start watching valuations. By getting a good sense of what a particular stock is worth, you can feel comfortable buying when Mr. Market is willing to sell the stock for less than its true value. This way, the pressure is off you to guess the near-term trajectory of the stock.

The wonderful world of Disney
Let's use Disney's (NYSE: DIS) stock as a guinea pig for a moment. Based on a simple discounted cash flow valuation using results through 2007, I might have concluded that Disney's stock was worth about $34 per share a few years ago. Applying a 20% "margin of safety" to that number, I would have found shares attractive at anything below $27.

In early 2008, Disney was trading in the high $20s to lower $30s, so I would have steered clear. However, in early October 2008, the stock had fallen to a point where it was right in my sweet spot. If I bought right as the stock hit $27, I would have then had additional opportunities to increase my investment at better prices between October 2008 and March 2009 -- when the stock was more than 40% lower.

Even if I didn't buy additional shares at lower prices, today I'd be sitting on a 37% gain on my original $27 purchase (not to mention some dividends collected along the way). Not bad for a holding period of less than a year and a half.

Better still, to bag those gains, I didn't have to make guesses about the short-term movements of Disney's stock.

That was then, this is now
Disney's stock has increased significantly from its recessionary lows, and even though the company has grown and become more profitable, the stock seems a bit overvalued today. So if you're looking to "time" Disney on the basis of valuation, it may be worth waiting for better prices.

But Disney isn't the rule. Though the market as a whole has recovered a good chunk of its losses, there are still plenty of stocks that are ripe for the picking. Here are three stocks that I believe are trading at attractive levels today.

Source: Author's calculations based on data from Capital IQ, a Standard & Poor's company.
*20% discount to intrinsic value.

Not only do these look like undervalued businesses to me, but they're all very high-quality businesses. As the world's largest retailer, Wal-Mart continues its relentless push forward, continuing to win over customers with its rock-bottom prices. Lockheed, meanwhile, is one of the big dogs in the defense world whose products include the F-22 Raptor, the Aegis Weapon System, and the upcoming F-35 Lightning II Joint Strike Fighter. And, finally, there's Transocean, which, as the largest offshore driller, should continue to benefit from the oil and gas industry's thirst for new resources.

The band will play on
Market timing is unlikely to ever be put to rest. It's simply too tempting to believe that you can fortuitously jump in and out of the market at just the right times to be able to capitalize on its biggest moves. But I've yet to see evidence that this can actually be done, and as far as I know, Miss Cleo doesn't trade stocks.

But if the litany of successful value-oriented investors -- from Graham to Buffett to Schloss -- tells us anything, it's that focusing on valuation and buying stocks for less than their true worth can produce great long-term results.

The examples above show that you can find great investment opportunities without having to guess whether the market is about to jump, jive, or dip. And those three stocks aren't the only ones worth buying today. The team at Motley Fool Inside Value is heading to the annual Berkshire Hathaway conference this weekend to learn more from Buffett himself about tracking down these kinds of undervalued opportunities. If you’d like to hear what they learn, sign up here for dispatches.

Fool contributor Matt Koppenheffer owns shares of Berkshire Hathaway, but does not own shares of any of the other companies mentioned. American Express, Walt Disney, and Wal-Mart Stores are Motley Fool Inside Value picks. Walt Disney and Ford Motor are Motley Fool Stock Advisor recommendations. Ctrip.com is a Motley Fool Hidden Gems selection. Berkshire Hathaway is an Inside Value and Stock Advisor selection and the Fool owns shares of it. The Fool's disclosure policy has never once been caught with its pants down. Of course, it doesn't actually wear pants ...