Value Investing 101: Kroger

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).

If you hold GE, how long will you have to wait for a $40 stock quote? The short answer: I don't know. The wait could be a couple of months or it could be a couple of years. Pessimism permeates the market, making it difficult to secure bids that approximate value. Even if you have to wait two years, though, you'll get some nice benefits. Not only will you collect $2.48 a share in dividends (assuming there is no change in the dividend payout), but your asset will likely be more valuable in a couple of years. It's reasonable to expect that GE's business value may reach $47 or $48 a share by 2010.

Note that your cost basis in GE stock is irrelevant in applying the rule above. Whether you paid $4 or $40 for your stock doesn't matter. In deciding whether to sell the GE stock in your IRA, the only numbers that matter are the current price and the current value.

Read the full version of Value Investing's Golden Rule: Whirlpool, GE.

From Value Stock Investing: CarMax, Overstock.com:

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.

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.

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.

Read the full version of Value Stock Investing: CarMax, Overstock.com.

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