This was originally published on RealMoney. It's being republished as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.It's the ultimate nightmare. You're sitting down at a table in a game of strategy. You're betting your lifetime savings. And then you realize something that shakes you to your core. You realize that you don't understand the game. Whether they recognize it or not, many investors are living the nightmare. They're risking their lifetime savings in a game of strategy called the stock market, and, unfortunately, they don't understand the game. To Play the Game, Understand This: The Purpose of the Stock Market Is to Facilitate Liquidity Everybody knows that shares can be bought or sold in a matter of seconds in our all-cash, no-contingencies stock market. The market does an amazing job of providing liquidity. But that's all it does. The important takeaway here is not what the concept says, but what it doesn't say. The stock market does not provide valuation appraisals. The purpose of the market is to tell you price. It does not tell you value. Also, the market doesn't exist to make you happy. It doesn't exist to make money for you. It doesn't exist to tell you how smart you are. It's not that the market is mean or evil. The market is indifferent. It doesn't care if you win or lose. Last summer, I thought I was smart when I loaded up on Tecumseh Products ( TECUA), paying $17 per share. With two of the company's three operating divisions sold, its financial statements required numerous adjustments prior to calculating value. Post-adjustments, the company was debt-free with excess net realizable cash (or soon-to-be realizable cash) of $400 million; it had a $1.1 billion (sales) compressor business worth more than $420 million.
The company was worth at least $820 million, or $40 per share, according to my calculations. By the way, I've increased the valuation to a range of $48 to $50 after data in the latest 10Q filing indicated that I underestimated the model's near-term margin leverage in my original calculation. Although stocks eventually migrate to value, anything can happen over the short term. In a panic selloff, TECUA cratered to below $10 per share shortly after I paid $17 for the stock. Do you believe stock prices approximate value? Do you label a stock purchase as smart or dumb on the basis of short-term price movements? If you do, then in the aftermath of the TECUA selloff, you'd have to say that I was not just dumb, but really dumb. To Play the Game, Understand This: Price Does Not Equal Value The evidence is overwhelming that price does not equal value in the stock market. When was the last time a company received a takeover offer that equaled, to the penny, the share price? It doesn't happen. Look up the 52-week price range for your favorite stock, and you're looking at all the evidence you need to prove that price does not equal value. While the average business changes in value by less than 10% per year (less than 1% per month), the average stock price changes by more than 50% per year. All stocks are mispriced. Some are mispriced by a little, some are mispriced by a lot, but all are mispriced. A value-centric investor embraces this construct when evaluating stocks. When value exceeds price by a wide margin, it's time to consider buying. Here are a couple of current examples. I expect these stocks to be more than 100% higher by the time price catches up to value. Office Depot ( ODP): The savvy analyst knows that what counts is normalized operating performance. Since prices are invariably predicated on "more of the same," prices get way out of whack in the outlier years. The nadir of the cycle is marked by excess pessimism, while excess enthusiasm predominates at the zenith of the cycle. The best investing opportunities, then, can be found in companies like Office Depot, which are temporarily operating at subnormal levels.
My base case valuation for this stock, at $30 per share, is based on the company achieving one-half of the margin improvement targeted by management. The stock recently traded at $13.74, down from a 52-week high of $36 per share. Investors in this stock will not have to wait long to see a rebound in operations. Numerous internal initiatives, such as expansion of higher-margin private-label offerings and sourcing of product to China, are already well under way. Mueller Water Products ( MWA.B): There are a number of facets to this story that are certain or near certain: that Mueller Water is the No. 1 or No. 2 player in most of the water infrastructure markets in which it participates, that there are high barriers to entry in most of its end markets, and that the company has a huge installed base that drives recurring revenue (i.e, replacement parts). The good news for investors in this stock is that the company's subnormal operating performance is almost entirely due to external factors -- about one-third of sales are linked to new residential construction. The value of this company is at least double the current stock quote. It recently traded at $8.80 per share. My model suggests a value of $22 to $24 in a couple of years. It's worth noting that the American Society of Civil Engineers assigned a grade of D-minus to current water infrastructure. With leakage rates running as high in 20% in some areas, studies indicate that $180 billion needs to be spent over the next 20 years to fix our water infrastructure. Since I can't predict when an impetus to fix our water infrastructure will develop, I've excluded such a scenario from my valuation calculation. I mention it only because it represents significant upside to my estimates. Note that there are two classes of stock, A and B, for Mueller Water Products. While the B series has superior voting rights, I expect the classes to merge into one class in a couple of years. A tax issue related to the spinoff from Walter Industries ( WLT) prevents changing the stock structure for a few more quarters. This column was originally published on RealMoney on May 19, 2008 at 1:00 p.m. EDT. For more information about subscribing to RealMoney, please click here.