Value Investing's Golden Rule: Whirlpool, GE
07/14/08 - 12:45 PM EDT
Arne Alsin
Here's the longer version, applied to the Whirlpool example above: Absent a material change to the business (there has been no impairment to Whirlpool's value), as price declines (the price drops from $90 to $60), risk declines (risk declines because the gap between price and value increases), and your anticipated rate of return increases (selling Whirlpool is dumb, because your capital increases 100% if you hold the stock from a $60 quote until you can get full value, or $120).
To understand the formula better, let's take it apart, piece by piece: The Qualifier Absent a material change to the business... When there is a material change to the business, sufficient to impair the underlying value, the formula does not apply. Here are a few examples of a material change: a permanent loss of market share, product obsolescence and a reduction of profit expectations over the long term. The current imbroglio surrounding financial companies is a material change, and it requires a valuation adjustment. For example, owners of Citigroup (C Quote - Cramer on C - Stock Picks), Lehman Brothers (LEH Quote - Cramer on LEH - Stock Picks) and Washington Mutual (WM Quote - Cramer on WM - Stock Picks), among many others, have suffered equity dilution while, at the same, time, billions of dollars of assets have disappeared from their balance sheets. What about the recession? Does a recession constitute a material change, sufficient to warrant a diminished business valuation? The answer is, generally, no. A cyclical pullback in the economy does not affect the long-term value of most businesses. That's because smart analysts already factor cyclical pullbacks into their valuation analysis. The fact that Whirlpool is struggling with a cyclical decline in demand is no big surprise. Not only is the current cycle not a surprise, but skilled analysts will build at least one more difficult cycle into their model for the next 10 years. Price As price declines... If your neighbor offers you one-half of the value for your car, you'll probably laugh it off. If a stranger parades into your family-owned business and offers you one-half of value, you might roll your eyes or shake your head. You might even be offended. That's because you see these offers for what they are: nonsense.
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