Value Investing's Golden Rule: Whirlpool, GE - TheStreet

This was originally published in two parts on RealMoney. Both parts are being republished as one article as a bonus for TheStreet.com readers.

Part 1: Stand Firm When Your Shares Take a Hit

Get inside the mind of the average investor, and you're in for wild and crazy ride. Metaphors like "the glass is half-full" or "the glass is half-empty" don't apply -- they're too tame. When the glass is brimming to overflowing, investors see it as empty. And when the glass is empty, investors cradle it with care so they don't spill the contents.

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The up-is-down, down-is-up mind-set of the typical investor is evident in this example: An investor figures that

Whirlpool

(WHR) - Get Report

is worth $120 per share. (Note: My calculations indicate a higher value.) The investor pays $90 per share for the stock and happily imagines taking a $30 profit when the price eventually migrates to fair value. Then the investor watches the stock quote fall from $90 to $80 to $70, and then to $60. The price drop is proof, to this investor, that he made a mistake. So he sells the stock.

It's a dumb move. If there is no long-term impairment to Whirlpool's value, it's dumb to sell the stock just because the price quote has dropped.

Investors make dumb moves in the stock market with regularity. It's not because of a lack of intelligence, a lack of effort or a lack of attention. The proximate cause of dumb moves is a lack of understanding. You can't play a game of strategy if you don't understand the game.

Here is a foundational formula for investing in the stock market. Investors suffer significant capital destruction when they act in contravention to this rule. Memorize it. Imprint it into your memory. It might prevent you from making a dumb move in the market.

Here's the short version: Absent a material change to the business, as price declines, risk declines, and your anticipated rate of return increases.

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) - Get Report

,

Lehman Brothers

(LEH)

and

Washington Mutual

(WM) - Get Report

, 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.

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) - Get Report

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.

Remember the reciprocal of the rule.

Unbridled enthusiasm over stocks is coming; I just can't tell you when. Optimism will envelop the stock market and prices will soar to excessive levels. It's difficult to fathom in the context of the current market, but it will happen. It will be the flip side of the current market.

Today, bargain-priced stocks abound. It's easy to find companies whose stocks are trading at 50 cents per dollar of value. And there are lots of quality companies whose stocks are trading at 20 or 30 cents per dollar of value. Two or three years into the next bull market, though, it will be difficult to find bargains.

How can you protect yourself from getting caught up in the enthusiasm in the next bull market? You can protect yourself by remembering the reciprocal of the rule above. That is, as prices increase, risk increases, and your anticipated rate of return decreases.

This was originally published in two parts on

RealMoney

(July 7 and July 10, 2008). For more information about subscribing to

RealMoney,

please click here.

At time of publication, Alsin and/or ACM was long Whirlpool, although holdings can change at any time.

Arne Alsin is the founder and principal of Alsin Capital Management, an California-based investment advisor. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback;

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