Easy Steps to Becoming a (Better) Value Investor: Part 4


Part 1 of this article, margin of safety, is available here. Click here for Part 2, "1,000 Rocks," and here for Part 3, "Conviction."

An oft-cited tenant of value investing is discovering the undiscovered and uncovering the covered. Well, with many of the large-cap stocks out there today, it's pretty hard to discover something the legions of analysts haven't. That's not to say it's impossible, but why make your job harder than it needs to be?

Small- and micro-cap stocks offer investors greater return potential than many of their larger counterparts while in some cases offering less risk -- contrary to popular belief. Critics will say the volatility and liquidity issues facing small and micro caps keep investors away. But you aren't a multibillion-dollar hedge fund with large liquidity needs and investors to soothe; you are the individual investor who can profit in the nooks and crannies unreachable by the big boys.

The stats
Don't believe me that small caps outperform? As shown in a report by value research and investment group Royce Funds, $10,000 put into the CRSP 6-10 (an index of the bottom half of market caps in the NYSE) in the year 1926 would today be worth nearly $100.4 million, versus $23.4 million in the S&P 500 (not counting dividends). To bring those numbers down to earth while also illustrating the power of compounding returns, the CRSP 6-10 earned an annualized return of 11.3% versus the S&P 500's return of 9.5%.

Now, investing from 1926 to today is just a tad longer than most of our investment horizons. And when you look at the big bull markets, such as the '80s and '90s, the large caps do tend to outperform. Here I will make an improvement on a statement I made in a previous edition of this series: "One should aim to keep up with the S&P 500 in bull markets and to lose less than the S&P 500 in bear markets." This goes back to our previous lesson on the importance of capital preservation and also addresses the relative strength of the S&P during up times.

If you are investing mainly in the S&P 500, you can expect to enjoy those juicy returns in the easy years, but you will also suffer from the downturns -- unless you have exposure elsewhere (hint: it rhymes with "mall raps").

Mall raps
OK, so small caps are great. Now what?

Let's take a look at a small cap I have been interested in lately: Vonage (NYS: VG) . As opposed to many no-name small and micro caps, Vonage is a company most of us know because of its aggressive advertising campaigns. The $518 million company offers voice-over-IP services to the United States and abroad. In 2006 it was a hot, typically overvalued IPO that came out of the gates around $17 per share and slid straight down to hit a low of $0.33 in 2009. It currently trades around $2.20 per share.

Vonage was billed as the next big thing in telecom and, needless to say, didn't live up to the hype. Microsoft's (NAS: MSFT) Skype was a buzzkill for the company, offering a similar product at a better price -- for free. Internet phone customers swarmed Skype and similar services instead of paying for Vonage's cheap but not-cheap-enough service. The market reflects a certain lack of confidence in the company: It trades at 1.77 times its trailing 12-month earnings. In the meantime, the company has paid down its long-term debt to nearly nothing and trades at about six times cash flow.

The market doesn't care too much about Vonage these days, because the hype is over, people are uninterested, and the tech investors are looking for the next big thing. But small-cap value chasers may notice that what keeps Vonage from really pulling ahead in earnings is its advertising spending. Without the massive ad campaigns, Vonage would be raking in the cash and trading at nearly 2.5 times cash flow -- which is incredibly cheap.

There are two options for the company with regard to the ad-spending situation. The campaigns could pay off, and usage could go up -- an obvious boom for the income statement. Alternatively, the ad spending could be nixed. This would slow business way down over time, but it would free up an enormous amount of cash in the short term -- giving investors a more profitable business for a couple years and thus an opportunity to earn large returns.

This isn't high-level analysis, folks. You don't need a physics degree from Harvard to uncover this situation. I saw the extremely low P/E, took a look at the fundamentals, saw that the founder owned 20% of the company, and started asking why.

Small and micro caps are great places to do your value research, as they attract lower valuations due to the market's typically cold treatment of small companies. Don't be intimidated if you haven't heard of the company. If it's in an industry you're familiar with, you already know how to rate the business; just treat it like any other.

The value world, though, has interests other than small caps. For a look at some larger companies that the smartest value investors are buying, take a look at this special free report.

The article Easy Steps to Becoming a (Better) Value Investor: Part 4 originally appeared on Fool.com.

Fool contributor Michael Lewis owns none of the stocks mentioned above. You can follow him on Twitter @MikeyLewy. The Motley Fool owns shares of Microsoft. Motley Fool newsletter services have recommended buying shares of Microsoft. Motley Fool newsletter services have recommended creating a synthetic covered call position in Microsoft. The Motley Fool has a disclosure policy.We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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