To Find Value, You Have to Have an Edge

It's a fallacy embraced by many investors: To generate huge gain, you have to absorb huge risk. To a value investor, it's just so much nonsense. Risk and reward do not march in lock step. Value-centric investors know it's possible to generate huge returns with low risk.

The value-centric investor "insures" against risk by buying shares at a discount -- by paying a price for stock that is materially lower than value. My risk is low if I buy shares of a company at 50 cents per dollar of value. My potential reward is a 100% gain. What if I can buy the same shares at 33 cents per dollar of value? All things being equal, buying shares at 33 cents per dollar of value involves lower risk because the gap between price and value is larger. And the potential reward of buying at 33 cents per dollar of value is much larger -- a 200% potential gain.

How do you find stocks that are selling at 50 cents or even 33 cents per dollar of value? The answer is easy to state, but difficult to put into practice: You have to be able to see things that other investors do not see. The world is full of investors that will tell you what you already know. Scores of investors are willing and able to tell you everything you need to know about wonderful companies like Google (GOOG - commentary - Cramer's Take) and Amazon (AMZN - commentary - Cramer's Take).

Do you think you've identified the next big winner? Then tell me something I don't know. Tell me what you see that others don't see. Identify a specific variable in the valuation equation that the crowd of investors has overlooked or misinterpreted. Here are a couple of stocks that illustrate the point.

CarMax (KMX)

Most investors do not yet know that the CarMax (KMX - commentary - Cramer's Take) model is a game-changer. The company is revolutionizing used-car retailing the way Charles Schwab (SCH - commentary - Cramer's Take) changed the brokerage industry in the '70s, the way Home Depot (HD - commentary - Cramer's Take) changed home improvement retailing in the early '80s, and the way Bed Bath & Beyond (BBBY - commentary - Cramer's Take) altered the landscape of specialty retailing in the early '90s.

The typical investor is perfectly capable of figuring out the competitive edge at CarMax. You can start by reading the annual report -- something Warren Buffett surely did before buying shares in recent months.

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At time of publication, Alsin and/or ACM was long Carmax, Home Depot and Overstock.com, 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.