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There are many who count themselves value investors. In fact, they are really what Seth Klarman calls “value pretenders”. It is easy to be a value pretender. I was one. Following Pabrai blindly into buying Delta Financial cost me a lot of play money. Importantly, I learned the differences between a value investor and a value pretender.

A value pretender may not realize he is a pretender. He understands the difference between price and value. He understands that Mr. Market is here to serve him. He knows he should demand a margin of safety. He admires the value investing gurus so to the point of thinking they are always right. But he does not grasp the principals of value investing.

To become a true value investor, we need to first understand the principals of value investing. Below are six principals I think are crucial for an investor to truly understand value investing:

Risk, not profit

Often, when you read a stock analyst’s report, you find the target price prominently displayed on the report. This gives investors the information he needs at a glance. The danger here is once the investor sees the target price higher than the current trade price, he skips the rest of the report and completely forgets about the risk. This is akin to lending your hammer to your neighbor because he promised to return two hammers when he still hasn’t returned the hammer you lent him two years ago.

Unlike a value pretender, a value investor does not target a specific return. Risk is what a value investor targets first. Understanding risk helps you avoid losses. Only after you understand the risks of an investment can you then calculate the rewards. An investment that promise a 50% return in one year is a lousy investment if there’s a 50% chance of the business going under in three months. But an investment promising a 20% return in one year with an 80% chance of surviving the downturn can be a wonderful investment. The rules of investing laid down by Buffett are simple — Rule No. 1: Don’t lose money. Rule No. 2: Don’t forget rule no. 1.

Do your homework, but not too much

Understanding the businesses behind your investments is what separates value investing from other investing approaches. To get to know your companies well, you need to do your homework and study the fundamentals of the businesses. Doing due diligence is a pain in the butt. In Investing Mistakes - 5 Deadly Sins, I talked about the hundreds of pages of annual and quarterly reports to read, not to mention the 8-Ks and proxy statements.

But investing is one activity where you don’t get paid by the hour. Here the general 80/20 rule applies; the first 80% of the most useful information is gathered within the first 20% of the time spent.[1] Don’t strive to find the perfect information about a company. Knowing the secret recipe of Coca Cola does not guarantee a profitable investment. At some point when gathering information, you will hit the point of diminishing returns. Embrace the uncertainty and imperfect knowledge about a company that make the company a bargain. Besides, if it’s too much work, you can always pass.

Maintain discipline and patience

A value investor knows to take advantage of Mr. Market when he is being irrational. Timing the market is futile. No one can reliably predict the direction of the market let alone when the direction will change. To overcome the uncertainties, a value investor must insist on a huge discount to allow himself a sufficient margin of safety.

A riskier investment warrants a bigger margin of safety and a higher discount rate to arrive at a more conservative value. A discount rate is the rate used to calculate the current value of future cash flows generated by a business. If the stock doesn’t trade at or below your margin of safety, just don’t buy. Yes, you may miss the opportunity of a ten-bagger, but don’t forget you may as well have saved yourself from a company headed for bankruptcy. If you are patient, eventually, the price will drop to your buy price. Then, you would have made a killing. Remember, the profit is determined the moment you buy the stock. If you buy at a bargain price, you are almost certain of success.

Bottom up, not top down

Many investors continue to worry about the state of the current economy as they read about the soaring bankruptcies, the rising oil prices, the growing unemployment and the worsening housing slump. In this environment, value pretenders will predict and identify sectors that will outperform the market and begin searching for bargains there. The problem with this top down approach is you are buying based on a trend, almost to the point of speculating. You’ve decided a sector will outperform before you can perform value analysis.

A value investor understands that a company that is fundamentally strong and run by competent management will ultimately survive the downturn. Searching for a bargain begins from the bottom; you find a company and learn about the company first, not the industry. Nevertheless, there are some industries like the airline industry that are just not worth investing in. Still, if you focus on the fundamentals of a company, you don’t need to worry about the economy and market direction. In the long run, the price always converges on the value.

Change your mind

One of the most essential virtue a value investor needs is humility. Everyone makes mistakes. No one can make the right decisions all the time, not even Buffett when he sold Anheuser-Busch too early and left a big chunk of change on the table. Buffett willingly admitted he made this mistake and that is why people admire the man.

More importantly, once we learned that we have made a mistake, we must be willing to take action even if it results in a loss. The obvious case here is to sell when you realized you made a mistake in your analysis of a company. Too, when hunting for a bargain, a value investor must not get too attached to his first love. Unlike a marriage, infidelity isn’t a bad thing in investment. He may find a better bargain as he continues his search. And when he does and he has no cash available, he needs to trade his first love, even if it’s at a loss, for the better bargain. This is very, very tough to do. This is what baffles many people when gurus switch from one position to another, even though there is nothing wrong with the former position.

Absolute performance, not relative performance

Setting the right goal and focus could mean the difference between devastating losses and reasonable successes. The trouble with focusing on beating the index is we are too competitive. It is too easy to succumb to the temptation of trading just to beat the index every quarter. Ironically, this is the very reason many mutual funds underperform the index. The mutual fund managers are not entirely at fault here because if the fund underperforms the index in a quarter money starts flowing out to better performing mutual funds. The general public demand for short term performance will continue to ensure mutual fund underperformance.

On the contrary, a value investor focusing on absolute performance should do quite well in the long run. By setting aside the need to beat the index every quarter, you are forced to focus on minimizing risk while earning a decent return. If you do this well, you won’t be too far off from the index performance. Buffett uses an internal score card to gauge how he does in life. He posits, “Would you rather be the world’s greatest lover and let everyone think you are the world’s lousiest lover or be the world’s lousiest lover and let everyone think you are the world’s greatest lover?”

References

1. Seth A. Klarman, Margin of Safety, HarperBusiness, 1991, p. 102 - 115.

Side note: My recent post Index Funds - What You Don’t Know was featured on the Carnival of Personal Finance #171. This week’s Carnival of Personal Finance will be hosted by Girls Just Wanna Have Funds. Be sure to check it out on Monday.

In How to Find Money to Invest, I suggested investors just starting out to invest in a low-cost index fund such as Vanguard 500 Index Fund. It’s a fine advice (because I gave it). Indexing is awesome because you don’t have to know a thing about investing. But even if you hate investing, the least you can do for yourself is to understand indexing.

John Bogle, the founder of Vanguard Group, started the first index fund in 1975 after Burton Malkiel popularized the efficient market theory (EMT) and commented “It is time the public can [buy an index].” The EMT basically says the stock price reflects all the best information currently available (even though it may be incorrect) about the company. Now that you know what EMT is, you can skip all 522 pages of Burton Malkiel’s A Random Walk Down Wall Street.

Because most mutual fund managers fail to beat the index, it makes perfect sense for the uninitiated investor to simply buy the index. But there are a few things you need to understand about indexing.

You will never outperform the market.

With indexing, you will at best earn a market matching return. In fact, when buying an index fund one of the most important factors to consider is the cost. The lower the cost the closer your performance to the index. By indexing, you are subscribing to the notion that the market is efficient. To put it bluntly, you are not willing to try to beat the market.

Warren Buffett wrote “in any sort of a contest — financial, mental or physical — it’s an enormous advantage to have opponents who have been taught that it’s useless to even try.”^[1] If you crave a market beating return, you will have to either pick your own stocks or invest in a mutual fund run by a guru.

You are not investing, but speculating.

Investing by definition is making buy sell decisions based on the difference between current price and perceived value. When you buy an index fund, you are not investing because you have no idea what you own. Yes, you know the tickers that belong in the index but you don’t know the companies the tickers represent. Since you don’t understand what you own, you will not be able to estimate its value.

In other words, you are buying in the hopes that the prices will go up not because the underlying of the securities will go up, but because you think the next buyer will pay a higher price. This is speculating. Don’t get me wrong. Speculating is not a bad way to make money if you loathe investing.

You are buying high and selling low.

As an index investor, you are inevitably buying high and selling low. When a stock is added to the index the price spikes. Similarly, when a stock is removed the price sinks. Two days after GameStop was added to the S & P 500 replacing Dow Jones, the shares surged 6%. This is because index fund managers were rushing in to buy the stock to match the index. With so many parties vying for a piece of the pie, it is only reasonable to expect to pay a higher price.

As a value investor, you just can’t help but wonder: Did GameStop just become more valuable overnight because it was added to an index? Did it really increase its future cash flow overnight?

You are forfeiting your shareholder rights.

At a typical stock corporation, shareholders get to vote on matters that are important to the company and themselves. It is also one way (albeit not the most effective way) of keeping tabs on management. Sometimes winning a proxy fight against management (think Yahoo!) could be quite lucrative for the shareholders.

However, when you buy an index fund, you are waiving your rights to vote as a shareholder. You are leaving the voting decision up to the index fund manager. The index fund manager’s only goal is to track the index closely. As a matter of fact, because the manager has no fundamental knowledge of the company, he is incapable of making an informed decision.

Prevalent indexing leads to poor returns.

This may sound counterintuitive: the more investors index, the more inefficient the market. Because everyone assumes the price correctly reflects the value of the security, no one will try to correct the price even if it significantly deviates from the underlying value.

Barron’s observed, “A self-reinforcing feedback loop has been created, where the success of indexing has bolstered the performance of the index itself, which, in turn promotes more indexing.” As I pointed out earlier, an indexed stock typically trades higher than its non-indexed counterpart. But, when the market goes south, matching the index return seems silly when the non-indexed stocks perform better. Thus, indexers rush for the exits, promptly dumping shares as we saw recently with Lehman Brothers.

Despite the gloomy picture I painted for index investors, it is important to recognize that index funds still kicked the pants off the majority of the mutual funds. But at the same time, it is also crucial to understand the implications of investing in index funds. At least you know what to look out for.

For those who abhor everything to do with investing, index fund is still the best way to go. In the end, what matters most is you get to enjoy collecting wine corks if that suits your fancy while earning a decent return on your investment.

References

1. Berkshire Hathaway, Inc., annual report for 1988, p. 18.
2. Seth A. Klarman, Margin of Safety, HarperBusiness, 1991, p. 50 - 54.

Side note: My recent post Finding Stock Ideas - Best Places to Look was featured on the Carnival of Personal Finance #170. Be sure to check out the abundant quality reading at this week’s carnival.

Welcome to the 106th edition of Festival of Stocks. The Festival of Stocks is a blog carnival dedicated to highlighting bloggers’ best articles on stock market related topics. This will include research and commentary on specific stocks, industry analysis, ETFs, REITs, stock derivatives, and other related topics.

I am proud to host the following selection of the best entries to the Festival of Stocks. This edition is arguably the most insightful I’ve ever seen. Thanks to all the authors for sharing your articles with everyone. Please keep ‘em coming.

Stock Analysis

Frank Lara Jr presents Friday Mailbag: “What to Buy?” (GE, AUY, BA, ZOLT, POT) posted at The StockMasters - Wall Street News and Commentary for the Savvy Investor
Getting back into the market after last week, what’s safe for the week ahead, a few stock picks and reasoning about financial blogs

Contrarian Profits presents 5 Fat-Dividend Paying Pharmacuetical Stocks posted at Contrarian Profits
Given the gut-wrenching financial turmoil of the last year, many investors are looking for more secure ways of investing. Floyd Brown says one way of doing this is to rethink the “boring” image of dividend-paying stocks. These stocks can offer great returns and a steady cash flow.

Bootstrap presents Boeing Boo-Boo? posted at Bootstrap Investing
Literally weeks after my post on the virtues of Boeing, the Machinists union refuses Boeing’s contract offer and threaten to strike. Great timing, right?

Michael Cintolo presents Lehman, Apple and Canaries posted at The Iconoclast Investor.
Back on May 29, I wrote an issue of Cabot Wealth Advisory that mentioned Lehman Brothers (LEH) as the canary in the financial coalmine. One thing for you to watch: Financial stocks … and Lehman Brothers (LEH) in particular.

Dividends4Life presents Stock Analysis: Nucor Corp (NUE) posted at Dividends 4 Life
Nucor Corporation is engaged in the manufacture and sale of steel and steel products. As the largest minimill steelmaker in the U.S., Nucor has one of the most diverse product lines of any steelmaker in the Americas. Linked here is a detailed stock analysis and commentary.

Steve Alexander presents Magic Formula Stock Review: ValueClick (VCLK) posted at MagicDiligence - Optimizing Joel Greenblatts Value Stock Strategy
ValueClick has a great business model and an attractive price. Only competition and the lack of a built-in moat prevent it from being a Top Buy.

Dividend Growth Investor presents UDR Dividend Stock Analysis posted at Create Rising Passive Income From Dividend Paying Stocks
UDR is a dividend champion as well as a component of the S&P 1500 index. It has been increasing its stock dividends for the past 31 consecutive years. Is this REIT a buy, sell or hold?

George presents Winners and Losers of the Fannie Mae, Freddie Mac Bailout posted at Fat Pitch Financials
Remember the Monday market madness after the Fannie Mae and Freddie Mac bailouts? If not, this post lists the most active stock winners and losers after that major market event.

Super Saver presents 9/8/08 Stock Position Update - It’s Ugly posted at My Wealth Builder.
As with last week, I continue to take no further action based on my buy list and short list of 7/7/08. So far I have taken four long and one short position, which has been closed. Given the volatility of the market, I continue to be cautious for both purchases and selling short.

Commentary

Robert D Flach presents THE FEELING IS DEMUTUAL posted at THE WANDERING TAX PRO.
Over the past few years many of the nation’s oldest and largest life insurance companies - including Prudential, John Hancock, MetLife, Principal, Mutual of New York – which began as mutual insurance companies have “demutualized”.

Jim presents Index Funds Are Only Part of Your Investment Plan posted at Blueprint for Financial Prosperity.
There isn’t a single reason why you shouldn’t like index funds. They’re cheap, they offer market rates of return without fail, and they are simple to buy. So why not put all your money into an S&P 500 Index fund like the Fidelity Spartan 500 Index or the Vanguard 500 Index, call it a day and enjoy more time with the family?

Pinyo Bhulipongsanon presents 5 Surefire Ways To Improve Your Investment Performance posted at Moolanomy.
Investing in the stock market is a risky business if you don’t know what you’re doing. Even if you do, it’s possible to lose a lot of money — e.g., Bear Stearns, Fannie Mae, Freddie Mac, etc.

Babak presents Richard Russell: Sage of The Dow Also Confused posted at Trader’s Narrative.
Far be it from me to criticize a luminary of technical analysis but it certainly appears that Richard Russell is confused. For those who are unfamiliar with him, Richard Russell is known as the Sage of the Dow for his expertise in Dow Theory.

Leon Gettler presents Volatility rules posted at Sox First
The US market has taken a hammering. Volatile times, perfect for for a trader with the agility of Spider-Man and the mathematical chops of Steven Hawking, but for everyone else, it’s just frustrating. Get used to it! Volatility is significantly greater in down markets than boom markets. The reason? Traders, like gamblers, chase losses. If they’ve lost lots of money, it’s tempting to make big bets to try and get it back.

Silicon Valley Blogger presents 14 Effective Strategies To Leverage A Weak Stock Market posted at The Digerati Life
There’s stuff you can do, even when the market is weak.

Raymond presents List Of the Best Online Discount Brokers posted at Money Blue Book.
So, you are finally sold on the idea of signing up for an investment brokerage account so you can start making money by investing in the stock market. Or, perhaps you are already an experienced trader but at times still wonder what other brokerage options are out there?

Finding the best stocks among the 13,000 publicly traded companies in the US is a daunting task. One of the most popular methods is to screen for stocks based on fundamentals. But screening stocks based on say a low price-to-earnings (P/E) ratio could inadvertently filter out stocks that may have high P/Es but are trading at less than cash. You could be missing out on some of the best ideas.

Based on my limited experience, I’ve found the following to be the most effective ways to find new stock ideas.

Steal from The Gurus

Investing is the only game where an amateur can beat the master at its own game simply by copying the master. I consider myself fortunate to be an amateur. The nice thing about being an amateur is you get to copy the masters like Bruce Berkowitz, Seth Klarman and Joel Greenblatt. Sometimes, you get really lucky and you get the opportunity to buy below the entry prices of the masters. In this case, you might just beat the master. To help us steal ideas from the investing gurus, the US Securities and Exchange Commission (SEC) requires investors holding more than 5% of a company to file a Form 13D. And a 10% investor to file Form 13G. Once the ownership crosses the 10% mark, the investor is required to report all additional trades on forms 3, 4 and 5. That’s a lot of forms to remember. Luckily for us lazy bums, GuruFocus keeps track of the gurus’ trades by scouring the forms filed with the SEC. So stealing ideas from Tom Gayner is now just a mouse click away.

Even though stealing ideas from gurus is both enriching and noble, sometimes gurus have ideas that don’t work out too. I fell into this trap once when I followed Mohnish Pabrai into Delta Financial. Despite losing quite a bit of money, Pabrai at least knew what he was doing. Me? I was clueless. But I was lucky to have invested with just play money. Lesson learned: Skipping homework was fun only when we were back in school.

Study Ideas From Value Investors Club

Another place to look for well researched stock ideas is the Value Investors Club (VIC), the brainchild of Joel Greenblatt of Gotham Capital. Greenblatt created the website to help him and peers discover high quality stock ideas. Message boards such as that on Yahoo! Finance contain more noise than facts. By creating an exclusive club of outstanding investors, Greenblatt and the members of the club get to cherry pick ideas from the smartest investors in the industry.

Since I can barely pass a Math exam, I was overjoyed to find VIC also offer guest accounts with a 45-day delay. So I don’t get to see the latest ideas and some comments are only viewable by members. But I still get to read the full analysis of the ideas. Be very careful here. Some ideas may read like great ideas. They don’t necessary turn out as promised. Make sure you read the annual reports and form your own opinion about the company before you invest. Even if you don’t find ideas that you act upon, you can still learn a whole lot from reading the analysis on the stocks.

Scour Insider Trades at Form 4 Oracle

Both Peter Lynch and Seth Klarman have emphasized the importance of observing the signals from insider trading. There are many reasons insiders would sell a stock, but there is only one reason they would buy a stock - they believe it would go up. Form4Oracle allows you to search for companies with the biggest insider open market purchases. This is a strong signal of insiders’ confidence in the company. But pay careful attention to the type of purchases. Open market purchases send the clearest signal because they require insiders to pay with cash out of their pockets. Exercising stock options, on the other hand, will only dilute existing shareholders.

Once you have found a company with high insider buying, dig deeper to understand the company and insider motives. Sometimes the best catalyst to narrow the price-value gap is to sell the company. But if the company is majority owned by insiders who have no intention of selling, you as a minority shareholder is left holding the bag.

Find Hidden Gems in 52-week Lows

Pabrai constantly scans the 52-week lows list to find stars that have faltered. You can find 52-week lows list on most financial websites such as Nasdaq. But finding a gem amongst stocks that have lost significant value is like navigating a minefield. Most companies trade at low prices for valid reasons. Only a handful may turn out to be deeply undervalued companies.

A good way to narrow down the list of stocks you need to scan through is to look for stocks trading at 52-week lows that are also owned by investing gurus. Again, GuruFocus offers a convenient way to track down these bargain stocks. The stocks you find here could be quite rewarding.

Listen to Randolph McDuff

This last method of finding stock ideas is a little unconventional. Randolph McDuff is the investment guru you’ve never heard of. His two model portfolios on Marketocracy earned annualized returns of 22% and 30% respectively since inception in 2001 compared to S & P 500 annualized return of -0.22% over the same period. You can invest in one of his Marketocracy mFolio portfolios for a fee.

Alternatively, you can follow Randy and his trades via his blog. Randy doesn’t write very often. This is actually good because someone once said, “If you find every stock a good idea, you are in big trouble.” Good stock ideas don’t come by easily. Otherwise, they won’t be good. I always wonder how publishers of investment newsletters come up with 10 new ideas every month. Randy discusses his reasoning behind picking the stocks for his model portfolio on his blog in gory detail. You can also ask him questions about his picks on his blog. An indisposable learning resource!

There you have it, my five best places to look for stock ideas. How do you find your stock ideas?

Side note: My recent post Are IPOs Smart Investments? was featured on the 105th Festival of Stocks and the 11th Investing Carnival. I will be hosting the 106th Festival of Stocks next week. If you haven’t submitted your articles, you still have some time. Don’t forget to check back on Monday morning for the best posts yet.

$2.5 million. That’s how much a $10,000 investment in Microsoft (MSFT) initial public offering (IPO) would be worth today. If Paris Hilton knew what an IPO is, she would say “That’s hot.” We all dream of owning that one hot stock that will transform us from a lowly wage earner to a philanthropist. But are IPOs worth betting our life savings on?

Before we get ahead of ourselves, let’s look at why a business wants to go public. A company could sell its stock to the public for various reasons including raising capital to fund future growth, providing seed investors a means to cash out, and increasing liquidity to avoid bankruptcy. Clearly, a company raising capital to avoid bankruptcy may not be a good candidate for an IPO investor. So it is important for IPO investors to understand the motive behind the public offering. Ideally, the funds from financing should be used to increase the intrinsic value (the sum of the present value of all future cash flows) of the business.

Even though the intentions of the company may be good, it pays to understand a little about the motivation of the parties involved in an IPO. There are four roles involved in an IPO:

Issuer
The issuer is the company that wants to sell its stock to the public. The company will receive the majority of the cash from the IPO after fees and commissions.

Underwriter
The underwriter is responsible for pricing and allocation of the shares to brokers. This role is usually played by investment bankers such as Goldman Sachs, Merrill Lynch and JP Morgan. Underwriters stand to earn up to 8% in fees from IPOs.

Broker
The brokers sell shares to investors or buyers. An affiliate of the underwriter usually also participates in this role. A broker earns between 15% and 30% in commissions.

Buyer
Buyers are mostly made up of institutional investors and high-net-worth investors. A very lucky few retail investors may get their hands on limited IPO shares.

Looking at the four roles, perhaps you can’t help but notice that the selling camp comprising of the issuer, underwriter and broker is a lot bigger than the buying camp. The issuer, underwriter and broker all stand to profit from the IPO regardless of how the company performs in the long term, except for the buyer. To launch a successful IPO, the issuer will work closely with the underwriter to price the shares to the advantage of both parties. A higher price translates to more cash for the company and fatter commission for the underwriter. It is only logical that the underwriter almost always plans to launch the IPO when the industry the company operates in is at its peak. The unscrupulous issuer might even exercise finance engineering to spruce up the company financials.

When pricing the new issues or shares, the underwriter usually prices it at a slight discount to its value depending on the market demand. This allows the underwriter to build a premium (usually 15%) into the opening trading price to entice buyers. In other words, average retail investors who hope to get in on the action are always paying at least full price for the shares the day the stock begins public trading. Always.

The broker of course has no motivation to look out for the buyer’s interests considering the broker earns the commissions no matter how well the stock performs. Furthermore, the broker earns a much lower commission in the secondary market, which is where investors resell the shares to other investors.

With these three roles on the selling side working against the IPO investor, how good can the deal be for the investor?

Dr. Yochanan Shachmurove wrote in a paper^[1]:

This paper investigates the actual performance of 2,895 Initial Public Offerings of companies that were backed by venture capital from 1968 until September 1998. In this paper we find that it is incorrect to assume that investors demand very high annualized and cumulative rates of return to compensate for the risks they are taking by financing ventures in different sectors of the economy. The mean rates of return are found to be, in practice, very moderate, and often, negative.

Despite the above arguments against investing in IPOs, not all IPOs are lousy investments. The problem is not many investors have the stomach to stick to their guns and wait for the stock to recover having lost 75% of its value two weeks after IPO. So they sell, not knowing had they held on to the stock they would have been millionaires in 20 years. One such example, Coca-Cola (KO), traded at $40 at IPO and plummeted to $19 the following year. Today, that share is worth over $5 million^[2].

Investing in IPOs may be a bad idea. But investing in the business several years post IPO may be the best idea you’ll ever find in your lifetime.

References

1. The Reality of IPO Performance: An Empirical Study of Venture-Backed Public Companies (PDF), Dr. Yochanan Shachmurove
2. Should You Invest in an IPO?, Joshua Kennon, About.com

Side note: My recent post Investing Mistakes - 5 Deadly Sins of Investing was featured on the 104th Festival of Stocks and the 10th Investing Carnival. Both carnivals offer some wonderful advice on investing.