Steer Clear of Value Investing Myths

Some people define value investing as sifting through a haystack full of penny stocks, looking for that one winning needle. Others see it as accumulating stocks that trade at unusually low price-to-earnings ratios and waiting for nature to take its course.

In fact, folks, there are probably as many ways to play the value game as there are stars in the sky. But before you start value investing yourself, you should be sure you understand what you're getting into and avoid some commonplace myths.

For instance, some investors seem to assume that simply because a stock is out of favor now, it will probably bounce back soon. I can't count the number of times I've heard both retail and institutional investors say, "The stock has gotta come back sooner or later -- and when it does, I'll make money."

But the trouble with this logic is that sometimes the stock never comes back. Or if it does, it's long after the investor has closed out his or her position, at a loss. Remember, it's earnings and news that drive stock prices. And without those two catalysts, a cheap stock could stay cheap forever.

One great example of this is when an analyst friend of mine (who prefers to go unnamed) recommended a company called Rag Shops (RAGS Quote) about five years ago. He assumed he had a surefire rags-to-riches story at $4 a share, given that the company was trading at about half of book value. But with its thin float and low profile among investors, the stock turned out to be dead money. Half a decade later, it still trades at about $4.

Another myth some investors seem to buy into is that numbers like P/E ratios can tell the whole story. But just about every industry has its own standards, and in a lot of cases those numbers are even more important than the broader measures. In the gaming industry, for example, analysts focus on earnings before interest, taxes, deprecation and amortization -- or EBITDA. In the banking industry all eyes are focused on book value and loan performance. In retail, it's same-store sales . Point being that investors need to know the standard before jumping the gun on just any company that trades at a low P/E.

Here's a great example of just what I mean. Earlier this month I recommended Hollywood Casino (HWD Quote) in my newsletter at $15.39. Some subscribers thought I was nuts, given that the company traded at about 44 times 2002 earnings estimates. But I knew better. At under 6 times EBITDA, the stock was just too cheap to pass up -- many gaming companies trade at up to 8 times EBITDA. And although the stock is up more than 12% since my recommendation, I think it still has 20% of upside from here.

Then there's the issue of insider selling. Some investors wouldn't touch a stock with a 10-foot pole if a top exec had recently sold some shares. But this type of thinking is a mistake. That's because there are lots of reasons an insider might sell stock, such as an option exercise or mere diversification. So my suggestion is to take a look at how much stock the insider is selling in proportion to his or her total holdings. If the sale is indeed a large percentage of the exec's portfolio, then worry. But otherwise forget it.

A terrific example of when I did just that is when I was analyzing InVision Technologies (INVN Quote). I recommended the stock in my newsletter in October when it was trading at $9.70. After just a month and a half the share price had moved up more than 40%! But one of its directors sold off more than 90,000 shares. To be honest, when the sale was announced I thought about selling off the position. But after careful consideration I realized that not only were the company's fundamentals still intact, but also that total insider ownership (still) topped 14% of the outstanding shares. So I held on. The end result was that I eventually sold the shares in November at $25.15 -- for a 159% gain in two months.

Bottom line: Avoid succumbing to these popular myths and misconceptions, and the odds are your wallet will be a little fatter at the end of the year.

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