Friday, October 13, 2006

Momentum Investing from a value perspective

Morningstar's Paul A. Larson explains how a value investor uses "momentum".

Newton's first law of motion essentially states that an object in motion will stay in motion unless acted upon by another force. As applied to stocks, it is my experience that equities also carry momentum, for a little while at least.

No, I don't plan on suddenly switching gears to play the "greater fool" game, buying the market's hottest stocks at high valuations and hoping to sell even higher. Quite the opposite. My plan is to take advantage of this momentum when it causes stocks to not reflect the intrinsic value of the underlying businesses they represent.

Usually a stock starts to fall when a company announces some bad news. But then investors start to get concerned about their paper losses, worrying that they perhaps missed something, and the selling continues. This additional selling begets more selling, with everyone fearful they are about to lose big. Momentum and fear have taken over, and the stock price often disconnects from the fundamentals.

When Mr. Market goes into a panic like this, there are often bargains to be found. We haven't had any screaming panics in the portfolios this year, but do consider Wrigley (WWY). Sure, the company has hit a speed bump with its acquisition of some of Kraft's (KFT) old brands, but is a few pennies in lost (or merely delayed) earnings per share really worth the stock falling by more than $10 per share since the beginning of the year? I think not.

I will also look to take advantage of inertia on the upside. When a stock I own starts to rise merely because it has recently risen and then trades well above our estimate of its intrinsic worth, that is when I will consider selling. (Early year 2000, anyone?) One might say I will attempt to take Warren Buffett's advice and be greedy when others are fearful, and fearful when others are greedy.

Inertia not only applies to things in motion, it also applies to things that are stationary. As Newton's law tells us, an object not in motion will remain not in motion, unless acted upon by another force. But in this case, Newton's first law is not always obeyed by Mr. Market, and the only force that matters in the long run is cash flow. Sometimes, the fundamental forces of an improving competitive position and growing profits apply a strong force on a stock, yet the stock does not move. This is a time to buy.

I've described this scenario before as a "pressure- cooker" situation, and at the moment, there appear to be many opportunities of this type. Take Berkshire Hathaway (BRK.B) and Wal-Mart (WMT), both of which we currently own in the Tortoise Portfolio. These companies have all steadily improved their core businesses and grown their profits in the past couple of years, yet their stocks have a lot of stationary inertia and have not gone much of anywhere in years, only recently showing some signs of life. In my view, it is only a matter of time before the forces created by the cash flow will be felt and these stocks will rise even further.

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