Value Investing's Golden Rule

The is the second of a two-part article.

All of history's great money managers adhere to the formula introduced in part one of this column. They may not articulate the rule the same way, but each understands and employs this formula:

Absent a material change to the business, as price declines, risk declines, and your anticipated rate of return increases.

Let's look at this all-important precept more closely.

Risk declines in concert with price.

Let's assume you own shares of General Electric (GE - commentary - Cramer's Take) in your IRA account. The stock has declined from $38 to $27 a share over the last few months. If GE's long-term business value has not been impaired, the price decline in GE stock coincides with a decline in your ownership risk.

The decrease in risk is seen in the increase in the spread between price and value. If GE's business is worth $40 a share (my calculation; the mechanics of how I arrived at this number are unimportant for the purpose of this column), the spread between price and value has widened from $2 a share (when it traded at $38) to $13 a share ($40 value minus $27 price quote).

Lower prices increase your anticipated rate of return.

In the face of falling stock prices, investors get stressed. There is a magic elixir that will eliminate the stress: Sell! Sell GE at $27 to eliminate your risk. Sell GE because the recent price decline might continue. Sell GE so you can invest in risk-free Treasury bills.

It might alleviate your stress, but selling GE at $27 is a dumb move. If GE is worth $40 a share, your ownership risk is low and your anticipated rate of return is 50%. If you sell GE after the price has dropped to $27 and invest in Treasury bills, you'll generate a 2% yield. If you hold GE and wait until you can get a price that approximates the $40 value, you'll generate a 50% return (not including GE's 4.6% dividend).

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At time of publication, Alsin and/or ACM had no positions in the stocks mentioned, although holdings can change at any time.

Arne Alsin is the founder and principal of Alsin Capital Management, an California-based investment advisor. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback; click here to send him an email.