The Art of Finding Diamonds in the Rough Fund manager Bill Nygren spots gemlike values where other investors see junk. In today's uncertain market, that's an approach you may want to mine.
By Carla A. Fried

(Business 2.0) – What's your definition of a hot stock? For most of Wall Street--and anyone who likes to shoot the breeze about "the market"--it's obvious. The best stock is a fast grower in a cool sector whose price has been climbing quicker than a scared cat and that has analysts abuzz about how it might just be the next big thing.

To Bill Nygren, manager of the successful Oakmark and Oakmark Select mutual funds, a great stock is about as far from that stereotype as any security can get. His ideal equity resides in a dull-as-dirt industry that hasn't been the next big thing for a long, long time. Ideally, its price has been falling instead of rising.

In other words, Nygren, 45, is a student of the venerable contrarian philosophy known as value investing. His goal is not to buy hot companies but to buy cheap ones. Follow this approach and you're all but guaranteed to feel left out of your friends' cocktail party chatter about how well their favorite tech stock did in 2003's bull market. But for investors who nervously recall how the previous tech bull ended, value may be the right approach for now.

Nygren's performance certainly makes a persuasive case for it. During the past five years, his Oakmark Select fund whipped the S&P 500 by an average of about 15 percentage points a year. In none of those years did he have what CNBC devotees would call a hot hand, especially when the bubble market was at its most gaseous. His funds were a study in steadiness, not flash.

Value investing, by its nature, is much less risky than chasing hot stocks. Nygren, for example, aims to buy companies when they are trading at least 40 percent below what he determines to be their "intrinsic value." Intrinsic value is a fairly esoteric concept, but you can approximate it by screening for stocks that trade well below the fair value suggested by standard yardsticks like price/earnings multiples. This approach offers a cushion in a downturn. Because their prices are already low, undervalued companies are unlikely to fall as steeply as others.

But cheap stocks are cheap for a reason, of course. No stock trades at less than 60 percent of its intrinsic value unless something about the company worries most investors. The key to value investing lies in distinguishing the stocks for which those worries are overblown from the truly hopeless cases. That process is as much art as science. But Nygren does follow a few simple guidelines that he believes improve his odds--and could do the same for any investor looking to learn from a master.

INVEST IN GOOD COMPANIES SUFFERING TEMPORARY SETBACKS. THEN HANG ON. Value investors favor companies that have recently trailed the market. But that doesn't mean you have to purchase perennial underperformers. "I don't buy the dregs," Nygren says. Instead, he looks for businesses with solid cash flow and little debt, and he likes companies with well-known brand names and strong positions in their industries. Then he tries to grab such stocks when some short-term hysteria puts them temporarily on the outs. For instance, he bought J.C. Penney in 2001, when most investors were hot on Target. By this year, Penney had doubled.

Nygren frequently expects that it will take a while for the companies he buys to mend. As a result, he often hangs on to shares for more than five years; the typical fund manager's average is nine months. Nygren's biggest holding in Oakmark Select now is Washington Mutual, the nation's largest savings and loan, which he started buying six years ago. He recently bought even more shares after the stock dropped 10 percent in the wake of a mortgage refinancing slowdown. "WaMu is moving into retail banking and adding 1 million new accounts a year," Nygren says. "Long-term, the story hasn't changed."

MAKE SURE MANAGEMENT WANTS WHAT YOU WANT. What makes a business consistently successful is leadership bent on improving the organization, Nygren says. One way he measures commitment is by checking how the leaders get paid. He prefers companies such as Liberty Media, owner of the Home Shopping Network and part of News Corp., in which the brass makes out when the stock performs well--and suffers with the shareholders when it doesn't. (You can check a company's proxy report at www.sec.gov for details on executive compensation.)

Often the best time to buy good management on the cheap is when it joins a down-and-out company. In 2000, Nygren noticed that Mattel's stock had plummeted more than 50 percent on the heels of its disastrous $3.8 billion acquisition of the Learning Company. But a new CEO, Robert Eckert, had come aboard after performing well at Kraft. Needless to say, Nygren saw a compelling toy story. The stock has since doubled, and Nygren still thinks it's cheap, noting that it currently trades at only 12 times next year's projected earnings. "It's the largest toy company in the world," he says. "It's hard to understand why Mattel shouldn't be closer to the market multiple." That would imply that there's still plenty of upside.

DON'T BE AFRAID TO LEAVE MONEY ON THE TABLE. The toughest part of investing is selling at the optimal time, and one key to getting it right is to set your exit price when you buy. Nygren cashes out when a stock nears 90 percent of what he considers its intrinsic value. Another practical preset sell signal might be when a beaten-down stock rises to a P/E greater than its long-term average.

Following this discipline, Nygren frequently has to walk away from the table when a stock appears to be at its hottest. But that's the essence of value investing: Buy a stock when most investors hate it, sell it before everyone loves it again. Such an agenda is a surefire way to preserve a margin of safety in a very uncertain world.

Carla A. Fried also writes about investing and the stock market for the New York Times.