How to Outperform the Market

 | Oct 12, 2011 | 12:00 PM EDT
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For investors, so much of 2011 was devoted to Europe, the U.S. political stalemate and deficits that the fundamental building blocks of investing seem to have faded into the background.

But political and economic problems are inherently temporary; they come and go in cycles. The key elements of successful investing are permanent. Applied appropriately, they always work. In fact, my close examination of the world's greatest investors of the past century -- John Templeton, John Maynard Keynes, Phil Fisher and Warren Buffett -- led me to write an entire book on these key elements.

The fourth quarter appears to be getting off to a very optimistic start. But before investors are overcome by optimism and jump back in, it's worthwhile to consider what leads to market outperformance. Even the best investors continuously strive to master and implement this framework. I break it down to six fundamental building blocks, but here are the crucial elements:

  1. Know how to value the business.
  2. Have the discipline to say no.
  3. Be ready to bet big at the point of maximum pessimism.

Regardless of the fact that the S&P 500 delivered a negative real rate of return during the first decade of this century, utilizing the framework outlined above would very likely have led to capital appreciation. Don't think there weren't investors who made some serious money during the decade -- Seth Klarman, Warren Buffett's new hire Ted Weschler, Bruce Berkowitz, David Einhorn and countless others did.

Utilizing the above framework will not sidestep losses, though. In 2008, massive liquidations led to a selloff that didn't spare any long investors, but it set up an opportunity in 2009 that led to a windfall for anyone ready to invest at that maximum point of pessimism.

Pessimism is near a peak for construction-related businesses, and for good reason. But the intrinsic value of Terex Corp. (TEX) over the next few years is significantly higher than its current share price, around $13 at midday. Coming out of the Great Recession, shares zoomed above $30 from $7. At a cyclical peak, sales and earnings were $10 billion and $530 million, respectively. If half of those profits come back in next several years and you apply a multiple of 12, you get a market of nearly $3 billion vs. $1.3 billion today.

At today's prices, Citigroup (C) trades for 8.5x earnings that have been depressed by non-performing assets and a weak environment. Absent those issues, the business is changing hands for less than 6x core earnings. This multiple depression only exists because the market is so disgusted with financials right now that it can't see beyond the short term.

You can also add Latin American steel company Ternium (TX) to that list. Trading at around $21 per share midday and with more than $2 per share in net cash, TX is trading at less than 3x enterprise value/EBITDA. The company enjoys a very low cost of production, generates massive amounts of free cash flow, yet the assets can be acquired for 65% of book value.

The consistent way to make money through investing has never changed: buy a business when it is cheap and sell when the price is dear. Pessimism creates bargains, while optimism creates bubbles. Many stock prices are 15% to 20% higher today than they were at the end of September. It's always easy to buy when markets are going up -- it's difficult to buy during turmoil. Yet time and again, we see the rewards of buying amid fear. This time it's no different.

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