A Different Approach to Value

Editor's Note: These are extracts from the Oct. 5 and Oct. 12 TheStreet.com Value Investor newsletters from Jon Markman.

You may find that my style of value investing differs somewhat from those of other managers, but that should not come as much of a surprise. There are as many kinds of value investing as there are shades of gray.

At the end of the day, however, all value investors focus on a simple concept: We try to buy shares of companies when they are relatively cheap and their stories misunderstood, and try to sell them when they grow to be relatively expensive and their stories widely appreciated.

Very often, the shares of those relatively cheap and misunderstood companies are trading near one-year or multiyear lows. But sometimes they are trading near all-time highs.

In the former case, we may take on some risk to assert that we know something that the rest of the market doesn't know. We buy into negativism, distaste, anger and regret, and wait patiently for the mood to turn apathetic, then hopeful, happy and finally optimistic.

In the latter case we may take on somewhat less risk to assert that while a few early investors understand the company's potential value, we believe that in the future many more currently sidelined, skeptical or unknowledgeable market players will be persuaded to become holders.

In both cases, we develop an intellectually advantaged variant perception of a company's prospects after an analysis of its fundamental financial structure and executive culture. This means combing through its balance sheet, income statement, cash-flow statement, proxy filings, public comments, insider buying and board governance. But we'll also study the world in which the company operates: talking to customers of its products or services or trying them ourselves, studying the major owners of the shares, and observing the recent history of its trading pattern. In addition to cheapness, we are looking for a catalyst that will drive prices higher.

Finding the Diamonds

There are about 3,000 tradeable stocks (market capitalization over $100 million, average daily trading volume more than 30,000, price over $2) to choose from. How do I sort through them all for the ones with the right stuff, and then distinguish myself from other value investors to make a final decision on the deployment of our precious capital?

First, I use a proprietary, multifactor, nonlinear model to help me assess and weigh the key, quantifiable decision-making inputs. This model, which has been tested both historically and in real time, helps me determine whether, for instance, a company with strong cash flow and low valuation but high debt, a modest dividend yield and a lousy chart deserves an investment as a surprise "turnaround" play. My model removes some, but not all, of the fear, doubt, excitement and personal bias that creeps into pure, seat-of-the-pants value stock-picking.

But numbers are only part of the story because these days, plenty of other investors have great quantitative models. Although each modeler believes he or she has a unique set of inputs and weights, at the end of the day the dirty little industry secret is that they are all pretty similar. And that similarity has put a lot of investors in a world of hurt in recent years, as many have put on the same trades, depressing potential returns.

For my final choices, I will depend on my experience and intuition -- two human attributes that pure quantitative investors shun. I try to peer into the back-story behind the numbers to observe moments when investor sentiment may have begun to shift in ways that don't show up well statistically. In this way I attempt to combine methodologies that are often kept separate by warring camps of investment ideologues -- fundamental analysis, technical analysis, quantitative analysis and sentiment analysis -- to generate valid value ideas.