From Joshua Kennon,
Your Guide to Investing for Beginners.
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Before you can see a transformation on the horizon, it is vital that you understand the true source of a company’s earnings (e.g., from an investment standpoint, Google is not a search engine; it’s an online advertising agency with prime virtual real estate that happens to be driven by search). Sara Lee, for example, is in the middle of a massive, sweeping restructuring program. If management executes well, the new company will be a fraction of its former size with less debt, fewer shares outstanding, and a core group of businesses upon which it can focus. At the end of the day, however, critics maintain that the source of the company’s earnings will remain the commodity-like, low-margin, fiercely competitive packaged foods business; although the company may be in better shape for the future, it hasn’t fundamentally changed its long-term prospects as its prosperity is still tied to a business growing in the low single-digits. Nevertheless, this can still represent a big opportunity for astute investors; in addition to the rich dividend yield, Sara Lee spun off Coach, a designer and retailer of luxury handbags, several years ago. Since that time, Coach shares have appreciated over 1,000%.

Management Change

Assuming you’ve paid a rational price, the quality of management can have a massive impact upon the returns you, as an investor, earn on your stocks. Typically, managerial talent should be evaluated on two separate fronts: executive and capital allocation.

• Execution
  At the end of the day, how good of an operator is the executive? Going with some of the companies we’ve already discussed, Sam Walton was a retailing genius. His ability to be a first-rate operator is what brought his enterprise to the forefront of the American commercial scene. Likewise, Roberto Goizueta was a brilliant manager that caused shareholders of Coca-Cola to grow very, very rich during his tenure as CEO. In other words: can they figure out how to sell the widget better, faster, or cheaper? Can they improve customer satisfaction? Can they take profitable business from competitors by executing well in the market place, day in and day out?

• Capital Allocation Every dollar of capital is unbelievably precious. CEOs who realize this basic truth are much more likely to generate market-beating returns. Imagine you owned a business with a 15% return on equity that retains all of its profits for expansion. The business isn’t particularly glamorous, nor is it loved by Wall Street. Over the next fifty years, every dollar you don’t spend today on unessential items such as gold-plated executive washrooms and Persian carpets will result in $1,084 more capital. Assuming it earns the same rate of return as the core business, that is $162.60 additional profit in the terminal year. For a business valued at the median price to earnings ratio of the S&P 500, the additional profit would add $3,252 to market capitalization.

  Put another way: If the CEO could figure out how to generate one-time savings of $100K by cutting costs, his company will increase its market capitalization by $325.2 million in fifty years. Tom Murphy, famed former CEO of Capital Cities (merged with ABC, then later with the Walt Disney Company), understood this principle. Legend has it that he once ordered his subordinates to paint only the front and sides of his headquarters so he could save the expense on the back half of the facility.

  How can you apply this to your investments? If the CEO of a company is taking precious capital and using it to chase after empire-building, low-return acquisitions (e.g., Hewlett Packard’s disastrous merger with Compaq, the Time Warner and AOL combination, or Gillette’s purchase of Duracell batteries) run for the hills. Unfortunately, even the best businesses aren’t immune from poor allocation; many, many decades ago, Coca-Cola was actually involved in shrimp farming.

If you know of a company that has been plagued by either poor operators or bad capital allocation decisions, you may want to pay attention if a change in management is announced. In most fields with decent business models, a good executive can mean the difference between mediocre and spectacular returns.

Final Tips for Finding Undervalued Stocks

Keep in mind that these are just ideas for places where you can begin to seek for value. Sometimes, a stock is cheap because it deserves to be cheap - either the business model is falling apart or the management is unethical.

For more great resources and helpful hints, check out our value investing resources.