How Value Investing Can Work for You

Value investing has been my preferred investment strategy for a long time. As a result of market inefficiencies, it's sometimes possible to find a stock that has become massively undervalued. Usually it happens when a company becomes widely misunderstood. Investors who find these stocks and then patiently wait for the market to recognize its error can be handsomely rewarded.

Let's look at some of the major opportunities and risks associated with value investing, using the case of Hewlett-Packard as an illustrative example. Then we'll examine one of the best value investing opportunities available in the market today.

The big opportunity
When stocks go out of favor, they often plunge to levels that can't be justified based on an unbiased reading of company fundamentals. The drop could occur because momentum-selling exaggerates a correction in the market, or simply because investors mistake a company's short-term downturn for a long-term decline.

This situation can create a big opportunity for value investors. A combination of those two factors sent Hewlett-Packard stock into a tailspin in 2012. Management turmoil, frequent strategy shifts, and poor reactions to emerging trends in the fast-moving tech world quite justifiably caused HP stock to drop from its all-time high above $50 in early 2010 to less than $30 in early 2012.

Hewlett-Packard 5-year price chart; data by YCharts.

In its early 2012 trading range of $26-$30, HP was trading at a multiple of 7, which was probably close to fair value. The S&P 500 typically trades in the 14 to 16 range, but it's not uncommon for stocks facing earnings pressure to maintain a high-single-digit P/E ratio. However, at that point, momentum took over. HP stock's 2012 collapse was aggravated by two big writeoffs and a weak 2013 outlook. Analysts and investors panicked and ultimately drove HP stock down to a multiyear low of $11.35 in November.

However, none of HP's 2012 disappointments really compromised the company's long-term outlook. In fact, HP has now beaten its guidance and analysts' estimates for two consecutive quarters, and the stock has more than doubled in the past six months. Value investors who bought HP stock at any point in late 2012 have been rewarded handsomely already, and I believe the stock has more room to run.

The main risks
The case of HP also highlights a major risk of value investing: buying too high. While many stocks see sharp drops at one time or another, that doesn't make them all good targets for value investors. Indeed, while HP was a bargain at $12 in late 2012, it could have been mistaken for a "value" opportunity earlier in the year, when it traded for nearly $30, as it had already dropped significantly from its early 2011 high near $50.

For that reason, demanding a "margin of safety" is a critical part of value investing. The "margin of safety" concept, made popular by legendary investor Ben Graham, means value investors try to calculate the intrinsic value of a particular stock -- based on the company's business prospects or liquidation value -- and will buy a stock only if it falls significantly below that level, thereby providing some room for error. That's good, because calculating intrinsic values is not an exact science!

HP stock may have been below its intrinsic value in early 2012, as it was trading for just seven times earnings. But given the competitive pressures facing the company, the stock probably didn't deserve a multiple beyond eight times. (Even today, when the stock has come back into favor, it trades for just seven times earnings.) In other words, there was little or no margin of safety for investors.

By contrast, at its fall low, HP traded for a little more than three times earnings. At that point, HP was still generating plenty of cash flow, and so even a conservative estimate of intrinsic value should have been at least six times earnings. For comparison, Dell -- which is in an inferior competitive position because of its higher exposure to the slumping PC market -- bottomed out with a P/E of approximately 5 last fall. Thus, HP stock provided a big margin of safety at its low point.

The HP case suggests a second "risk": panicking. The same market inefficiency that creates value investing opportunities also means that a stock that drops into "bargain" territory can continue falling for quite a while. Investors who bought HP stock at $17 last fall have made big gains in less than a year -- but only if they didn't panic and sell when the stock fell below $12!

One way to mitigate the risk of seeing your value stock fall further is by averaging into the stock over time. By starting with a small position and then buying more stock every month or two, you'll be able to take advantage of any further declines in the stock price -- which should increase the margin of safety, assuming no change in the company's intrinsic value.

You need plenty of patience and discipline to be a successful value investor; you often have to wait years -- not months -- for a stock to return to fair value. So you should invest only money that you don't need for at least five years.

A value opportunity today
One of my favorite stocks today is Hawaiian Holdings , the parent company of Hawaiian Airlines and a great value investing opportunity. While the rest of the airline sector has gone on a tear in the past six months, Hawaiian has been unable to gain traction. It trades for about 5.5 times 2012 EPS, or 4.5 times expected 2014 EPS.

As I've discussed previously, Hawaiian is in the midst of a rapid international expansion that has depressed its margins (airline routes usually take two to three years to reach peak profitability). The company appears to be widely misunderstood, as its trading multiple implies that investors expect declining profitability in the long run. In fact, the company's recent margin decline is almost certainly a temporary phenomenon: Management has argued persuasively that the business will turn a corner in the second half of 2013.

I believe Hawaiian's profit margin is likely to return to its historical levels of 6% to 8% by the middle of the decade, which could produce EPS of $2.50 or more. However, even in a downside scenario where Hawaiian's profit margin remains at its current depressed level indefinitely, the stock should be worth at least $8 (approximately eight times earnings). That's similar to the valuation of United Continental, which is expected to produce similar pre-tax margins between 4% and 5% for the next two years.

With Hawaiian's stock trading more than 25% below its intrinsic value, the stock offers a substantial margin of safety. The company therefore represents a great target for value investors who are willing to wait for it to return to its intrinsic value.

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The article How Value Investing Can Work for You originally appeared on Fool.com.

Fool contributor Adam Levine-Weinberg owns shares of Hewlett-Packard and Hawaiian Holdings and is short shares of United Continental Holdings. He also has long September 2013 $33 puts on United Continental Holdings and long October 2013 $6 calls on Hawaiian Holdings. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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