Cash In on Your Faith in Undervalued Stocks

Nearly a half-century ago, Eugene Fama, a University of Chicago economist, laid out the hypothesis that markets are efficient — that is, at any given moment, the price of a stock reflects all the information the public knows. The current price of, say, Apple (symbol AAPL) is the consensus view of thousands or even millions of investors who have weighed everything they could possibly glean that would affect the company: its past and current earnings, balance sheet, product prospects, global monetary policy, the chance of war with Iran, and on and on. The efficient-market hypothesis, or EMH, asserts that today’s price is the “right” price and that tomorrow’s price will reflect information that is unknown today.

The EMH is generally considered a strong justification for buying index funds. By owning a large number of stocks, such as those found in Vanguard 500 Index (VFINX), you reduce volatility through diversification, pay rock-bottom fees (0.17% of assets annually) and get returns that mimic the market. Over the long run, those returns won’t be much lower or higher than what you’d get by picking stocks on your own or through a mutual fund managed by an actual human being. (Stocks and funds in boldface are those I recommend.)

But while you probably can’t gain an edge on the market through superior information or analysis, you can benefit from the EMH in a different way. A stock’s current price is based on all available information. So why not take a guess that the unknowable future will turn out to be a good one? Yes, a guess, but a guess that is based on a strategy.

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For example, concede that you don’t know what Apple’s next great product will be, but take a guess that something big will come along. Or, in the case of a company that is struggling, as International Business Machines (IBM) was in the early 1990s, take a guess that someone great will turn the company around. Because neither you nor any other investor knows what that something or someone will be, the information is not currently reflected in the stock price. The way you get an edge is through your belief that things will get better than other investors think.

This is what I call faith-based investing. It is not a religious concept, but neither is it the agnostic act of throwing darts at a newspaper stock table (if you can find one these days). To profit from the approach, you need to find companies that have four attributes: a great brand, a solid balance sheet, a long-term history of growth and an undervalued stock.

Betting on laggards. The object is to find companies that are currently faltering but that have a high likelihood of doing better. Their brands are so valuable that their owners won’t let them languish or die, and their record of profitability proves that they have a competitive advantage and can be resuscitated.

Buying IBM in the 1990s may be the best example of successful faith-based investing. From 1987 to 1993, the stock price fell from $44 to $11 (adjusted for subsequent splits). No one knew that Lou Gerstner, who was not a tech maven, would rescue the company. And hardly anyone could have guessed that he would do it by selling off the personal computer business and concentrating on services. Six years later, IBM was trading above $130.

Or, more recently, consider Netflix (NFLX), the firm that utterly disrupted the movie-rental business. Netflix shares fell from $305 to $62 in just four months when the company launched a new pricing scheme that caused many consumers to grumble. But I kept the faith. I wasn’t sure how Net­flix would thrive, but I knew it would. “Netflix is built for the long run,” I wrote here a year ago. The stock now trades at $213 (prices are as of May 3).

Apple is a potential faith-based winner. A great brand? No doubt. Solid balance sheet? Yes, with $143 billion in cash and securities and no debt. History of growth? Yes, earnings increased every year from 2003 to 2012, and revenues over that time have gone from $6 billion to an expected $181 billion for the fiscal year that ends this September. Cheap? The shares, at $450, are down 36% from their 2012 high and trade at 11 times estimated earnings for the current fiscal year. After results for the January–March quarter were announced on April 23, analysts at numerous Wall Street firms cut their price targets on Apple’s stock. Clearly, analysts have little faith in Apple today, despite CEO Tim Cook’s announcement that the company will spend an additional $100 billion for dividends and stock buybacks through the end of 2015.

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Apple’s profits have soared 50-fold in a decade on the strength of the iPod, the iPhone and the iPad. What’s next? There’s talk of an iWatch, but frankly I haven’t the foggiest idea what Cook is cooking up. If I did, thousands of others would know, too, and Apple’s price would reflect that knowledge. What I do know is that Apple is going through a tough time, competition is rising, faith in its future is falling. It meets the tests for a good faith-based investment.

Another example is Merck (MRK). The drug maker has been languishing for three years now. Its earnings have barely budged, and the stock is lower than it was in 2001. In 2012, Singulair, an asthma medicine that had $3 billion in annual sales, became the company’s latest blockbuster drug to lose patent protection. Still, Merck is one of the strongest consumer brands in the world, trades at 13 times estimated earnings, gets the Value Line Investment Survey’s top rating for financial strength (A++) and yields a lovely 3.8%. So if you have faith, you can collect a hefty dividend while waiting for a savior—that is, a product, person or change in strategy.

Fund for the faithful. No mutual fund employs a true faith-based strategy. (What manager would admit to guessing?) But one, ING Corporate Leaders Trust (LEXCX), comes close, though inadvertently. It was launched in 1935 with the idea of selecting 30 firms that would survive and grow for decades. The portfolio changes only with bankruptcies, mergers and spinoffs. Just 22 stocks remain, and nearly all of them meet the faith-based tests of great brand, strong balance sheet and solid earnings growth. Some, at times, are unloved as well.

The results have been superb. Over the past ten years, Corporate Leaders gained 11.2% annualized, beating Standard & Poor’s 500-stock index by an average of 3.4 percentage points per year and placing the fund in the top 1% of funds that invest in big companies with a blend of growth and value attributes.

Among the fund’s holdings with all four faith-based attributes are Chevron (CVX), the energy behemoth, with a price-earnings ratio of just 10 and a yield of 3.2%; General Electric (GE), with a P/E of 14, a yield of 3.4% and a price that’s down by half since 2007; and chemical giant DuPont (DD), which is benefiting from low natural gas prices, trades for 15 times earnings and yields 3.3%.

Faith-based investing should not be confused with bottom-fishing. For instance, shares of Gannett (GCI), once one of the great media companies, have fallen 77% since 2003, but it is not a faith-based stock. The brand is good (though not on the level of IBM or DuPont) and so is the price (9 times estimated earnings). But growth is lacking (earnings have risen in only two of the past eight years), and the balance sheet is mediocre. Faith can supplant some analy­sis, but you need to use judgment, too.

James K. Glassman is founding executive director of the George W. Bush Institute, whose recent book on economic policy is titled The 4% Solution. He owns none of the stocks mentioned.