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Value Plays Aren't Built in a Day

Arne Alsin

Dumb luck can bail you out over the short term, but some sort of analytical edge is required if your objective is to outperform over the long haul.

A good mantra to embrace borrows from one of my RealMoney columns from five years ago: Give Me an Edge -- Or I Won't Play.

Give me an edge, or I won't play means that I'm not going to play the craps table or pull the lever on slot machines in Las Vegas. I don't have an edge in that environment. So I won't play. Figure out where your analytical edge is and don't stray.

In the stock market, I don't have an edge in predicting short-term price swings. Short-term prices are determined by supply and demand forces. You can see the supply/demand influence when a company like Google(GOOG Quote - Cramer on GOOG - Stock Picks) is added to the S&P 500 index. The supply of Google stock is static while demand increases (index funds have to buy the stock), causing a bump in the price of Google shares.

My edge is in my valuation work.

I can identify companies that are selling at a fraction of their value. On a buy-and-hold basis, for example, 18 of the 20 companies highlighted in my first two Top 10 Turnaround lists have outperformed the S&P 500, and by a wide margin: 169% for the list posted at the end of 2000 vs. -9% for the S&P 500, and 83% for the list posted at the end of 2001 vs. 10% for the S&P 500.

There is a problem with my particular edge, however. The short-term price inefficiency of the market is a two-edged sword. While price inefficiency provides for wonderful opportunities, it doesn't magically go away after a position is taken.

In the "Edge" column I recommended unpopular, widely scorned Office Depot(ODP Quote - Cramer on ODP - Stock Picks) over highly popular, widely admired Oracle(ORCL Quote - Cramer on ORCL - Stock Picks). Five years later, Office Depot shares have increased to $37 from $9, while Oracle shares have declined to $13 from $24.

In the two years following the posting of the Top 10 Turnarounds at the end of 2001, eight of the 10 turnarounds were down by 10% or more. Although all 10 are positive on a buy-and-hold basis as of today, several were down by 30%-40% subsequent to that column's recommendation.

Even if you nail your valuation analysis and secure an asset at a fraction of value, it's important to steel yourself against the potential for price declines. Over the long term, the market is remarkably efficient -- prices migrate toward value.

Over the short-term, though, supply/demand forces can wreck havoc on a well-constructed portfolio.

Top 10 Turnarounds for 2006 -- Update

Leading the way is Wild Oats(OATS Quote - Cramer on OATS - Stock Picks), which climbed to $20.33 at the end of the first quarter from its recommended price of $12.50 at the beginning of December. By my calculations, Wild Oats' value will grow to $34 a share by 2010, making it a worthwhile position to hold.

What are the best current opportunities from the 2006 list? Commerce Bank(CBH Quote - Cramer on CBH - Stock Picks) and 1-800-Flowers.com(FLWS Quote - Cramer on FLWS - Stock Picks) represent multibagger opportunities with low risk. Here are my notes.

Commerce Bank: The flat yield curve (short-term interest rates approximate long-term rates) has masked the earnings power of this franchise. My calculations indicate that the company will earn $4.67 a share in 2010, based on 20% deposit growth (this is a conservative assumption considering their track record) and a 4.1% net interest margin (the 10-year average is 4.4%). A P/E multiple of 18 times implies a stock value of $84 a share in 2010, more than double Friday's quote of $36.65 a share.

1-800-Flowers.com: The leverage in this operating model is impressive. The company has stated on numerous occasions that its objective is 8% operating margins in a couple of years. It's reasonable to expect the company to hit its target, given the growth in its high-margin Bloomnet business. My calculations indicate a valuation of $17.70 in 2010. It recently traded at $7.10 a share.