Microsoft Versus Apple

With Microsoft, expectations are so low that it's far more likely to deliver pleasant surprises.

One of the toughest calls we have to make as value investors is how much weight to assign a stock's price relative to the underlying company's growth potential. Pay too much and even stocks of the best companies can turn out to be clunkers. If, say, you had paid $70 for a share of Cisco Systems (symbol CSCO) in mid 2000, you would have lost 73% of your money to date, even though the company's earnings per share have quadrupled. How is that possible? Simple: In 2000, the stock traded at 194 times the previous 12 months' earnings. Today, it sells for 14 times trailing earnings. On the other hand, an inferior business selling at a cheap price can be a value trap -- a stock that appears inexpensive but goes nowhere or declines as the business fades (think newspaper publishers and check printers).

New thinking. Having had plenty of unfortunate experiences with value traps, we have shifted away from a price-is-all-that-matters mentality. We've noticed a similar evolution among many accomplished investors. For example, when we interviewed legendary hedge-fund manager Julian Robertson for our Value Investor Insight newsletter, he told us that his concept of value had changed over time. While he once focused solely on stocks with low price-earnings ratios and other traditional measures of value, he now takes a more flexible approach: "Something at 30 times earnings growing at 25% per year -- assuming I have confidence it will grow at that rate for some time -- can be much cheaper than something at seven times earnings growing at 3%."

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Whitney Tilson
Contributing Editor, Kiplinger's Personal Finance