Value Investing: What Are the Odds?

02/10/2014 9:00 am EST

Focus: STOCKS

Dennis Slothower

Chairman and CIO, Alpine Capital Management

Warren Buffett's Berkshire Hathaway will pay $1 billion to the person who correctly predicts the winner of every game during college basketball's March Madness, observes Dennis Slothower; the editor of Stealth Stocks explains how this bet can be likened to value investing.

Buffett, one of the best in the insurance business, is not going to risk $1 billion if the odds are not greatly in his favor.

Some have calculated the odds of selecting all 63 games on a bracket correctly as 1-to-9 quintillion (or 1-to-9,223,372,036,854,775,808, to be more exact). It's fair to say that Buffett stands a very low chance of losing $1 billion.

The point I'm trying to make is that when great investors make a wager, they do so only when the odds are overwhelmingly in their favor; otherwise, they walk away. Another way of looking at it is that they play not to lose.

Although they might not make money on every investment, the chance of taking a permanent capital loss is very small.

If you were looking to buy a stock based on the company's trailing 12-month earnings, would you rather pay $10 or $100 for every $1 of earnings?

Looking at it a little differently...if you bought the whole business for $1 million in cash and the business generated $100,000 in earnings, you would have made a 10% return on your investment. The business would be trading at a P/E of ten.

However, if you paid the same one million for a business that generated only $10,000 in earnings, your return would be 1% on your investment...and the P/E would be 100.

Studies have shown that over periods of 50+ years, stocks bought when they are trading for a P/E of ten, or lower, greatly outperformed those stocks that were bought at much higher P/Es.

One sign of a bear market is that many financially strong companies trade at attractive valuations. And a sign of an overextended bull market is that companies with very little to no earnings trade at extremely highs P/Es.

I'm currently looking at a few popular stocks that are trading at nosebleed valuations: Amazon.com (AMZN) trades at 660 times earnings; Netflix (NFLX) trades at 220 times earnings; LinkedIn (LNKD) trades at over 700 times earnings and Facebook (FB) recently traded at over 100 times earnings.

Some may argue that future earnings for these companies are so attractive that it is worth paying top dollar for them today. But if they hit a bump in the road on the way to those future earnings, these stocks would drop like a stone.

I hope that the dot.com bubble of 2000 is still fresh in your mind. Consider stocks trading at very high price levels, such as Twitter (TWTR), Pandora Media (P), and Yelp (YELP). Are these stocks that rational investors would be interested in...and be able to say that the odds are in their favor?

Buyers of any one of those stocks are paying a very hefty price for future earnings that may or may not happen. In my book, I call that speculating, not investing.

Buying a very overvalued stock is a risk all by itself. Now I want to add that the Fed is sucking the buying power out of the stock market by tapering, and you can see that the odds are heavily stacked against you.

I don't have a crystal ball to tell me where the stock market is heading, but I can say, with certainty, that buying overvalued stocks at this point in the market cycle is not a prudent move.

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