Keys to Successful Investing

Today's information flow is the best and most efficient in the history of Wall Street. The playing field is as level as it has ever been with respect to information. But it's not the access to or possession of information that is important: It's how investors process the information that separates the winners from the losers.

Wall Street analysts certainly have a plenitude of information about the companies they analyze. So why has so much of the analysis generated by Wall Street left investors wanting? Why have so many analysts been so thoroughly discredited in the last couple of years?

Part of the problem is that the information gathered by analysts is applied to a faulty analytical framework. In general, most Wall Street analysts make the same fundamental errors:

• Linear forecasts: Just because a company averages 20% to 30% earnings growth for a few years does not mean it is reasonable to project the same growth into the distant future. All businesses are cyclical; the only question for each is the extent of the cycle. And let's forget the term "noncyclical" -- it is a useless misnomer. The sooner Wall Streeters recognize that every company in every industry has naturally occurring cycles, the sooner they can help us make money.

• Earnings fixation: Analysis of businesses needs to go a lot farther than Wall Street's singular obsession with earnings. Detailed analysis of the balance sheet, for example, can identify assets that can be utilized to increase earnings, or conversely, debt issues that could limit earnings potential. There are many ways to create value besides a stream of earnings, including reorganizations, spinoffs, mergers, stock buybacks and so on.

• Make your quarter, or die! CEOs need to be given a little more rope than Wall Street currently grants for making quarterly numbers. Quarter-to-quarter earnings pressure is too high on Wall Street. Just because a company misses estimates by a penny or two does not justify lopping off billions from the company's market value. A greater focus on long-term earnings prospects would be more useful than concentrating on the next quarter or two.

As I have written before, I rarely give more than a passing glance to Wall Street research. It's too short-term oriented for a value investor like me, and too concentrated on variables that don't have anything to do with safety (for example, balance-sheet issues). My framework for analyzing businesses is decidedly different from what is offered by brokerage firms. Here are a couple of my keys to successful value investing:

Look for Margin Leverage

When most investors think about leverage, they think debt. But to me leverage means a lot more than adding up the liabilities on a balance sheet. One of the key levers to value creation is the ability of a company to dramatically increase net profit margins.

Here's what I mean by margin leverage: As I explained in a prior column, to the extent J.C. Penney (JCP Quote) can lift net margins from 0.5% to 3.5%, a level it has been at before, Penney stock would triple. That's significant margin leverage. On the other hand, if Microsoft(MSFT Quote) similarly increases its net margins by 3%, from 40% to 43%, it may be noteworthy, but the stock price would not change dramatically.

Look for companies that have below-normal net profit margins. See if you can identify catalysts that could drive margins back to normal levels. It doesn't have to get a lot more complicated than that. It's how I have found some of my biggest winners.

Think Capital Cycles

When a particular market is hot and profits are high, capital naturally flows to that sector. Inevitably, as competition increases and capacity builds, profit and the rate of return on capital decline. And then the cycle turns down. Capital flows out of the sector because of excess capacity and low profitability. That's the sweet spot of the cycle for me, as a value investor. I know that when I see capital flight, return on capital will eventually ratchet up for surviving companies -- until it gets high enough to attract new capital once again.

Evidence of a top in a capital cycle includes a proliferation of IPOs, peak profitability, and general bullishness and attention granted the sector. At the bottom of the capital cycle, companies go out of business, close divisions, lay off workers and have difficulty obtaining financing.

At each of the companies that I have recommended in prior columns, there are both margin leverage and evidence that they are near a low in their sector's capital cycle. This value strategy is working well. The 12 stocks I have recommended in prior columns are up an average of 17%; during the same period, all of the major equity markets have declined.