Value Investing's Golden Rule: Whirlpool, GE

When it comes to stock quotes, though, otherwise rational, sentient beings take on a wild and crazy mind-set. If you are like most investors, after you pay $90 for Whirlpool stock, the stock quote suddenly carries great meaning for you. It can make your day or it can ruin your day. Even if you don't sell the stock when the price drops, you'll tell your spouse: "We've lost one-third of our money on Whirlpool."

Here's the reality: There is no difference between your neighbor's offer for your car, the stranger's offer for your family-owned business and Whirlpool's stock quote. Each is an offer for your property. Each is an offer you don't have to accept. The offers are not based on a careful appraisal of value. They're just offers.

After your neighbor's offer, you aren't going to say, "I lost one-half of my car value today." And after you hear the stranger's offer, you won't announce: "One-half of our family business value disappeared today."

Do you know why you will not say these things? Because they are not true. It would be a dumb to accept a one-half of value offer for your car and for your family business. A lousy offer is a lousy offer. And that's all it is.

Part 2: Value Investing's Golden Rule

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 Quote) 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).