INVESTING COMMENTARY

• The Next Big Thing in Investing
• Foolish Fundamentals: Stock Dilution
• 10 Most Popular Articles
• Foolish Fundamentals: Same-Store Sales
• Don't Let Them Scare You
• The P/E Illusion
• Can You Smell the Market's Fear?

The Next Big Thing in Investing

By Mathew Emmert
April 25, 2006

Do you find yourself spending a great deal of time looking for the latest and greatest investments? To some extent, I suppose every investor does. But tomorrow's leaders are easier to find than you might think. In fact, that's the philosophy on which I base my dividend-stock newsletter, Motley Fool Income Investor, where we're beating the S&P 500 while taking far less risk.

I sometimes marvel at how many folks squander their investing energies looking for the next Microsoft or Yahoo! (Nasdaq: YHOO), two tech wunderkinds that crushed competitors to post nearly 18% and 37% annualized returns, respectively, over the past 10 years. I receive a good number of emails from such investors, who often ask for my opinion on lesser-known companies. And more often than not, they say, "Word is, it's going to be the next (fill in the blank) of the oil industry" or "the pharmaceutical business" or "the software market."

It seems everybody wants to find the company of the future, not the company of the now. Investors spend countless hours buying into the dreams of upstart businesses in the belief that this company or the next will invent a better light bulb and make them rich beyond belief. I certainly see the appeal there, but most investors are better off putting their efforts into researching companies that are already the best at what they do. While a few upstarts might indeed make money for early investors, most won't.

Buy tomorrow, today
In all likelihood, the next Microsoft is probably going to be, well, Microsoft. Companies that generate more than $13 billion a year in free cash flow don't often disappear. In fact, they typically go right on crushing their respective markets -- or at least keeping a sizable share of them -- year after year.

After all, these companies have the capital, the resources, and the global distribution networks. They enjoy multibillion-dollar research-and-development budgets. They own the brand names that roll off our tongues without a second thought. Why wouldn't they dominate tomorrow as they do today? Truth is, most of them will.

The untrodden road is a tough road
The life of a fledgling company is difficult, of course. For every company like Microsoft or Yahoo! that hit it big, thousands of startups never quite made it.

Some businesses didn't have the right leaders or, at some delicate stage of their existence, were sunk by a single bad decision. Consider this: If IBM had recognized that the true profit potential lay in software, not computers, Microsoft might not exist today. Or what if Apple Computer (Nasdaq: AAPL) had won its copyright infringement lawsuit against Microsoft way back in 1988? Windows might not be the world's best-selling operating system.

Imagine if Excite hadn't blown all its cash on dubious acquisitions and advertising expenditures. Perhaps it would be today's Yahoo! rather than a forgotten domain name owned by IAC/InterActiveCorp (Nasdaq: IACI). There are numerous events that, if they had gone another way, would have resulted in these companies not being here -- at least as we know them.

That's how speculative most of these situations are. Even the most successful companies likely had more "50/50" moments than they'd care to remember. That's just the life of any young company. Yes, when you hit one out of the park, it feels great -- and doing so can result in spectacular returns. But for most of us, one or two great calls won't make up for 20 years of bad ones.

The point is that you can dramatically reduce your risk and most likely enjoy better results by choosing high-quality, dividend-paying companies with which you're already familiar. Putting your research efforts into buying those businesses at great prices will likely generate far superior returns than trying to unearth the company that will cure cancer.

Well done, not well known
Some of these companies are the brands you know and love. I recommended Newell Rubbermaid (NYSE: NWL) to my members because it is trading for less than its intrinsic value and offers a greater than 3% yield. Then there are companies such as PepsiCo (NYSE: PEP) and Cadbury Schweppes (NYSE: CSG) that offer less than 3% yields yet boast incredible competitive advantages and moats.

But you also don't have to relegate yourself only to those companies with popular names. For instance, a business such as AllianceBernstein (NYSE: AB) is hardly a household name. But it is a blue chip in the investment management industry and living proof that you don't have to speculate on biotech to earn sizable gains. The company has generated a total return of more than 90% for Income Investor subscribers in a little less than two years.

Whether the masses generally recognize it or not, these are conservative businesses operating in proven markets, and those are the types of companies you should commit yourself to owning. We're not looking to build wealth in a week and lose it in a month. We're hoping to build wealth over a lifetime.

Suffice it to say, I don't want to be "50/50" anything. I prefer to succeed far more often than I fail. And by doing so, I believe I can deliver market-beating returns to your portfolio while allowing you to rest your head on your pillow comfortably when the lights go out.

So if you'd like to get some extra sleep while building wealth, consider a no-risk, 30-day free trial to Income Investor. You'll receive access to all past recommendations, and it won't cost you a dime.

This article was originally published on Dec. 12, 2005. It has been updated.

Mathew Emmert sleeps well at night, but he has been known to snore occasionally. In case you didn't notice, he is the author of Motley Fool Income Investor. Of the companies mentioned in this article, he owns shares of Microsoft and PepsiCo. Microsoft is an Inside Value recommendation. The Fool has an ironclad disclosure policy.

Foolish Fundamentals: Stock Dilution

By Motley Fool Staff
April 28, 2006

Stock dilution refers to the issuance of additional stock by a company, for any purpose. Some of those purposes are bad for outside shareholders, some are neutral, and believe it or not, some are actually good. Let's look at all three scenarios and see how they would affect us as investors.

Let's start with a make-believe company that we can use as a guinea pig to show how its actions can affect its shareholders' ownership stakes. Imagine that this company is a high-tech start-up that aims to one-up stun-gun manufacturer Taser (Nasdaq: TASR). It's got a new weapon to sell that can be set not just to "stun" but also to "disintegrate," a feature that leaves nothing of its target behind but a hollow afterglow. The company is called Phaser (Ticker: RAYGUN). In 2005, Phaser had 100,000 shares of common stock outstanding, a market cap of $1 million -- and $100 of net profits.

Now, we need one more guinea pig. Let's call this one Joe Fool. He's an individual investor, and on Dec. 31, 2005, he bought 10,000 shares of Phaser stock. When the company reported its earnings, Joe was elated to learn that, by virtue of his ownership stake, he vicariously earned $10 worth of Phaser's profits. Little did he know what 2006 held in store for him.

strong>Bad stock dilution
In 2006, Phaser decides to engage in the worst of the three main ways that companies dilute their shareholders: It issues 100,000 stock options to its CEO. For the time being, Phaser has a "basic share count" of 100,000 shares actually outstanding. But because its CEO will eventually exercise his stock options (i.e., tell the company to issue 100,000 shares to him and then sell them on the open market), Phaser now has a hypothetical, or "diluted," share count of 200,000 shares.

That's bad news for Joe. While he will still own his 10,000 shares, his ownership stake will be diluted once the company issues that extra stock. What does that mean? Well, when Phaser's share count stood at 100,000, and it earned $100, Joe was entitled to 10% (10,000/100,000) worth of those profits, or $10.

But when Phaser issues those 100,000 extra shares, Joe's shares will not equal 10% but just 5% (10,000/200,000) of all shares outstanding. If Phaser earns $100 again in 2005, Joe's take from that haul is just $5. Poor Joe.

The CEO, on the other hand, gets 100,000/200,000 worth of the profits, or $50. Lucky CEO!

Thus, the primary reason Fools dislike stock dilution is that it often represents a transfer of wealth from outside shareholders -- you and me -- to insiders.

Ambiguous stock dilution
Stock dilution, however, isn't always bad. But before we look at when it can be good, let's consider the iffy situation of a company that acquires another one and pays for the purchase in stock. Say Phaser wants to expand its business but it hasn't gotten its gun to work just yet. That poses a problem. As the solution, Phaser decides to buy out a rival, defense contractor General Dynamics (NYSE: GD). Since Phaser hasn't sold anything and doesn't have any actual, er, cash, it wants to issue its own stock to General D shareholders in exchange for their shares.

Now, General D has a market cap of roughly $20 billion. With Phaser shares trading for $10 a stub, our intrepid Trekkie will have to issue 2 billion new shares to acquire its heart's desire. Doing that will dilute Joe, and Phaser's other shareholders, by 200,000 times. In what universe could that much dilution possibly be a good deal for Phaser shareholders?

The answer requires another question: Is Phaser overpaying for its purchase? If Phaser pays a price equal to General D's intrinsic value as a business, then the dilution created by the purchase does not really hurt Joe. Yes, Joe's slice of the merged Phaser/General D pie looks much smaller than his slice of Phaser alone does. But the new pie is much bigger. Picture this: Joe's receiving a much thinner but also much longer slice of Phaser/General D pie, in return for his original wide but stubby slice of Phaser.

A smaller piece of a bigger pie
And there's another possibility to consider. Alone, Phaser may not be objectively "worth" the $1 million market cap that the market accords it. If Phaser's stock is overvalued, then paying for an acquisition in inflated-value stock may be a smarter move than paying in cash. During the go-go '90s, most every acquisition you saw from companies such as Cisco (Nasdaq: CSCO) or Microsoft (Nasdaq: MSFT) was paid for in richly valued stock. And should we see cash-rich companies such as Google (Nasdaq: GOOG) or Apple (Nasdaq: AAPL) making acquisitions, I'd wager good money that they, too, will nonetheless choose to pay in stock. (Interpret that as you will.)

Take my shares ... please!
And that brings us to the third major form of stock dilution: secondary offerings. When Phaser gives 100,000 shares to its CEO for a nominal "exercise" price, that's bad for outside shareholders. But what if, before Phaser decides to go that route, message-board rumor mill gets going and anoints Phaser as the next moon-rocket stock? As Phaser's stock price doubles, triples, and then jumps 10 times more, company management reconsiders, decides to not issue options, and instead sells the 100,000 shares on the open market -- at $600 a pop.

If the company's intrinsic value hasn't changed, and if only its stock price has increased, then this is great news for Joe. After the secondary offering is completed, he again owns 10,000 shares out of 200,000, or 5% -- down from his original 10%. However, Phaser itself is now worth more -- not just from the rumor-bubble pricing of its stock but also intrinsically, because the company has traded 100,000 shares for $60 million in cash. That cash now sits in the company's bank account, and Joe owns 5% of it, or $3 million.

So to sum up, whenever a company issues shares at a price higher than the shares' intrinsic value -- whether it does so to buy another company or to sell the shares and raise cash on the market -- an outside shareholder benefits, despite his or her percentage of ownership being diluted.

And there you have it: the three primary sources of stock dilution, and what they mean to you as an outside shareholder.

Taser is a Motley Fool Rule Breakers recommendation, and Microsoft is a Motley Fool Inside Value pick.

Rich Smith, Shruti Basavaraj, and Adrian Rush contributed to this article.

10 Most Popular Articles

By Selena Maranjian
April 28, 2006

On the New York Times website, I especially like to check out the list of most-emailed articles. It tells me which stories struck such a chord with readers that they wanted to share with others. That made me wonder which Fool investing articles our readers favored. After a bit of digging, I offer this list of 10 of our most-read recent articles.

Check some of them out -- whether you're learning something new about investing or discovering stocks to potentially buy or sell, your portfolio may thank you for it later.

"3 Sell Signs." by Rex Moore
Rex outlined some of the reasons that you might want to sell a stock you own. This is critical stuff, since knowing when to buy is only half of the equation for successful investing. He cited excessive executive compensation, aggressive accounting, active insider selling, and declining market share as red flags. "A classic example of this occurred at Tyco (NYSE: TYC) a few years ago, under former CEO Dennis Kozlowski's watch," Rex noted.

"Time to Hedge Your Bets," by Shannon Zimmerman
Shannon pointed out that some experts, worried about the stock market in 2006, are adjusting their investments accordingly. He recommended that readers consider investing in carefully selected mutual funds, among other things.

"How to Cheat the Market," by James Early
James offered some good and bad news. The bad: "Your odds of picking stocks that beat the market aren't good." The good: You can beat the odds. He cited some research by three professors showing that unloved, low-expectation value stocks tend to outperform high-priced, high-expectation glamour stocks.

"Massive Growth!" By Tim Beyers
In this piece, Tim marveled at the hype surrounding a penny stock, pointing out that there are plenty of great-performing companies around us that don't carry the risk of penny stocks. He listed seven examples, each of which grew revenue by more than 50% annually over the past five years. Two of the seven are J2 Global Communications (Nasdaq: JCOM) and Marvell Technology (Nasdaq: MRVL).

"Behold: The 'Highest-Rated' Stocks," by Selena Maranjian
In this article, I took issue with the Investor's Business Daily newspaper and the way it selects its most-promising investment ideas. The folks at IBD later took issue with me, and so I issued a follow-up article.

"A Broken Stock Full of Promise," by Tim Hanson
Tim related how he lost money on insurance company Montpelier Re (NYSE: MRH) -- and how, thanks to Tim, his father-in-law lost money on it, too. Click to read what he had to say about small-cap stocks and why he's hanging on to this one.

"The Case Against Small Caps," by Paul Elliott
Here, Paul shared some investing lessons that it took him 20 years to learn. In a nutshell, he explained why small-cap investors are often misguided and how we can make a lot of money by seeking out great values in the small-cap world. He pointed out how many small caps today are still miles away from being what Wal-Mart (NYSE: WMT) was in 1975 -- they don't have the revenue, income levels, or growth rates.

"How to Get Stinkin' Rich," by Richard Gibbons
Don't we all want to get stinkin' rich? Richard Gibbons does, and he explained how we can best position ourselves to succeed at it: "I learned at a young age the key to getting rich. ... Here's how it works. Every month, invest a certain amount of cash in great companies. Wait for a few decades." He offered an eye-opening table showing how big various modest monthly investments can grow, and he warned against speculative stocks: "Investors in Elan (NYSE: ELN) and Micron Technology (NYSE: MU) have experienced some volatile times for the last decade, but they would have basically just broken even if they had held for that whole time. A 0% return might not seem so terrible, but remember how important time is for compounded returns. Ten years of investment time was essentially wasted."

"The World's Hottest Stocks," by Stephen Simpson
Stephen noted that "Just last year, markets in Austria, Egypt, Turkey, and South Korea delivered better than 50% returns, and that's no one-year fluke." He then went on to discuss the merits of investing internationally, listing some foreign companies that have outperformed their American competitors.

"I Turned $3,000 into $210,000," by Selena Maranjian
In this piece, I explained how I ended up making a boatload of money on an investment and how I could have made even more. I also offered some tips on how others might find similar stocks.

In sum
These are just a few of our most popular articles. If you'd like to check out even more articles, bookmark this page and visit it often.

Here's to a happier portfolio! (And hey -- consider forwarding this article to anyone you care about. Just click on the "Email this page" link near the bottom of the page.)

Tyco is a Motley Fool Inside Value pick, while Montpelier Re has been singled out by both Motley Fool Hidden Gems and Motley Fool Stock Advisor.

Selena Maranjian's favorite discussion boards include Book Club, Eclectic Library, Television Banter and Card & Board Games. She owns shares of Wal-Mart. For more about Selena, view her bio and her profile. You might also be interested in these books she has written or co-written: The Motley Fool Money Guide and The Motley Fool Investment Guide for Teens. The Motley Fool is Fools writing for Fools.

Foolish Fundamentals: Same-Store Sales

By Motley Fool Staff
April 28, 2006

Every month, retailers announce their sales and comps growth. "Comps," which refer to comparable same-store sales, can help investors determine how well a company's brand is doing and how efficiently its stores are increasing revenues.

Each month, as the calendar page flips over, you'll hear announcements about things like Gap 's (NYSE: GPS) same-store sales dip or Starbucks ' (Nasdaq: SBUX) same-store sales rise. So what are these all-important numbers, and why do they matter?

Same-store sales, or "comps," measure sales growth at stores that have been open for more than a year. For a store to be able to count monthly comps for May 2006, it must have been open for the full month of May 2005. If the store opened May 15, 2005, comps couldn't begin to be counted until June 2006, a year after the store's first full month of business.

To understand quarterly and annual comps, simply replace "month" with "quarter" or "year" and apply the same concept. (Almost every retailer announces comps each quarter, but more and more are announcing them each month as well.)

What factors affect comps? The two main factors are prices and the number of paying customers. Revenues equal price times the number of sales, right? So all things being equal, if prices go up and volume stays the same, sales will increase. That also holds true if volume increases but prices stay the same.

Notice, however, that when a company has a bad month, it doesn't often attribute the problem to price or volume woes. Companies rarely say things like, "No one came to our stores on the 18th of the month, so comps declined." To their credit, some retailers, like Gap, have announced in the past that comps fell because of deeper discounts, but this kind of announcement is the exception, not the rule.

The usual suspects for falling comps are things like unusually placed holidays and very bad or very good weather. In defense of retailers, if a big shopping holiday is later in the year than usual, or if March had four shopping weeks this year as opposed to five last year, these things could hurt comps and would be beyond the company's control.

Now that we know what comps are and what factors affect them, let's see what these numbers mean for a company. First and foremost, rising comps are good. They indicate that more people are coming to buy things at the stores, or are paying more for the same things they bought a year ago, or some combination of the two. Either way, sales are increasing without the added costs associated with opening new stores. This shows that marketing is doing well and that the brand is popular with consumers.

Retailers can increase their revenues in two ways: by increasing them at existing stores or by increasing the actual number of stores. Obviously, the former approach is less expensive. Some companies, such as Starbucks and Wal-Mart (NYSE: WMT), have done both. Others, such as Gap and Pacific Sunwear (Nasdaq: PSUN), have increased their number of stores, but comps have been weak.

What about falling comps? When a company's comps are falling, it could mean one of a few things. It could mean the brand is losing strength and people aren't shopping at the company's stores. It could mean that the economy is worsening and people aren't interested in shopping anywhere. Or it could mean the company has too many items selling at discount prices. But one thing is certain: Falling comps represent a problem. In such a situation, the question to ask yourself is whether you're looking at a short-term bump in the road or the beginning of a long-term swoon.

This question is very difficult to answer, because you have to look at several factors to come to any sort of conclusion. And since that conclusion is an attempt at predicting the future, there's no guarantee that the conclusion will be correct. But there are a few indications that separate short-term problems from long-term ones. If negative comps are the most recent in a long string of negative comps, for example, that's a bad indication of a long-term problem. How competitors are faring is important, too. When Gap suffered from negative comps in both its most recent quarter and most recent month, so did several other apparel retailers.

Actually, looking at Gap leads us to a final point: Look at what the company said the problem was and what it planned to do about it. Gap has said many times that it had moved away from the core values that made it strong in the first place and was trying to refocus its brands around those values. At the very least, this admission shows that management saw the problem and was trying to fix it. The approach may not always work, but it was at least a sign that the company was moving in the right direction.

The most important thing to remember about comps is that, just like any other metric or number, it is a part of the picture, not the entire tableau. Just because comps are rising, that does not necessarily mean the company is a good investment. And likewise, falling comps do not always mean it's a bad one. The trends that you see, and the reasons for those trends, matter. Sales and margins matter, too, as does the overall financial health of the company. You want to consider all of these factors before making your investment.

Gap, Pacific Sunwear, and Starbucks are Motley Fool Stock Advisor picks. Take the newsletter dedicated to the best of David and Tom Gardner's picks for a 30-day free spin.

Bob Fredeen, Shruti Basavaraj, and Adrian Rush contributed to this article.

Don't Let Them Scare You

By Seth Jayson
April 28, 2006

Some people out there will tell you that you're banging your head against a wall by picking your own stocks, because you can't know more than the experts on the Street do.

I don't buy it. I don't suggest you buy it, either. It's possible for individual investors to be braver than the market and even, at times, smarter. I know, because I am one of those little investors, and I do it frequently enough to beat many of the experts on the Street. So long as I don't let them scare me.

Let me tell you ...
More than a year ago, I watched a company I knew fairly well, SanDisk (Nasdaq: SNDK), slide from a little bit undervalued (where I had begun buying my shares) to blood-in-the-streets cheap.

For weeks, I watched some of the savviest market-watchers out there predict all kinds of doom: a flash-memory glut, falling prices, and the end of demand because of slacking camera sales. I had knowledgeable industry professionals emailing me with all sorts of data that purported to show that flash demand was down, pricing was down, and terrible things were in store for SanDisk's margins and profitability.

I, on the other hand, believed that phones and convergence devices would provide a very large new growth stream. I believed that SanDisk's habit of working with device manufacturers like Nokia (NYSE: NOK) and Sony (NYSE: SNE) to create new card specifications would ensure a level of subsequent product sales as well as the potential for fat-margin licensing fees. And I believed that SanDisk's aggressive pricing strategy -- which some saw as a negative because of short-term margin blips -- would, over the longer run, be positive as it spurred consumption of larger amounts of flash memory.

From December 2004 through June 2005, SanDisk was trading for as low as 15 times earnings and at an average of 17, and I was dead certain it was primed for better than 20% growth. This was a spicy but classic value. It was the industry leader, deeply entrenched, misunderstood by worrywarts. And its potential growth was selling for a dirt-cheap price.

Turned out I was right
Flash demand grew more quickly than anyone expected, hitting a sprint pace when Apple (Nasdaq: AAPL) moved more of its hot-selling iPods to flash. In fact, Apple's anticipated need is so huge that it made the unprecedented move of paying chip makers such as Intel (Nasdaq: INTC) and Micron (NYSE: MU) to move into the market for it. Tight supply kept selling prices high. SanDisk saw a broadening market for its products in items such as media-rich phone models from Motorola (NYSE: MOT). This meant that earnings growth for the past two years has actually come in around the 40% mark. And since July 1, 2005, they have more than doubled.

Sounds like a success story? Only partially, because I made the mistake of letting the naysayers scare me. At least a little.

Yes, I held my shares, but I passed on the opportunity to load up in the low $20s. It was only when the tide began to turn and the stock ran back to the $30s that I started adding. Sure, those shares are up at least 80% too, but I know you're with me when I say this: I'd rather have had the triple from the $20s.

The moral of the story is simple. I gave it away at the beginning. Don't let them scare you.

There are a million reasons the Street might be frightened, but it doesn't mean you have to follow suit. The key to taking advantage of values is doing the math and having the guts to buy before it's too late. No, you won't always be right, but the odds will be in your favor. And over the long run, that's enough to give you the edge you need.

Do the work -- buy when the market won't. That's the philosophy we follow at Motley Fool Inside Value, where Intel was a recent selection. A free 30-day trial will let you learn more.

Seth Jayson will take the spicy values as well as the boring ones. At the time of publication, he had shares of SanDisk but no positions in any other firm mentioned. View his stock holdings and Fool profile here. Fool rules are here.

The P/E Illusion

By Aswath Damodaran
April 28, 2006

The accretion/dilution bogeyman
Price ratios remain the most widely used multiples in valuation, but they're also the most misused. Part of the reason for this is that there are widely held illusions about P/E ratios that color both acquisition valuations and equity research. In this article, I'll examine one of these illusions, centered on whether an acquisition will increase earnings per share (be accretive) or decrease earnings per share (be dilutive) for the acquiring company. Using the shorthand of dealmakers, the former are supposedly value-creating (and, therefore, good for acquiring company stockholders), whereas the latter are value-destroying and should be avoided.

To see the basis for the accretion/dilution illusion, consider a very simple example. Company A, with 1,000 shares outstanding, trading at $80 a share and earnings per share of $1 a share (P/E = 80) buys company B, with 8,000 shares outstanding, trading at $10 a share and earnings per share of $1 a share (P/E = 10). Whenever a high-P/E-ratio company acquires a lower-P/E-ratio company, as is the case here, the merger will be accretive. In this illustration, the earnings per share of company will increase substantially after the acquisition, irrespective of whether the acquisition is funded with cash or stock. In fact, if the acquisition is at a fair price (1,000 shares of company A are issued to finance the acquisition of 8,000 shares of company B), the earnings per share will be $4.50 a share after the transaction:

EPS after transaction = Net Income of Company A +
Net Income of Company B
----------------------------------------
Shares in Company A +
Shares Issued by Company A to buy Company B

= (1,000 + 8,000)/(1,000 + 1,000) = $4.50

It's at this point that the illusion kicks in. In the most extreme case, the shares of company A will continue to trade at 80 times earnings (as they did before the acquisition), increasing the price per share to $340.

The reality is unlikely to even come close to this optimistic scenario. If company A paid a fair market value for B, the P/E ratio for the company can be computed as follows:

P/E after transaction = Market Cap of Company A +
Market Cap of Company B
------------------------------------
Net Income of Company A +
Net Income of Company B

= (80,000 + 80,000)/(1,000 + 8,000) = 17.78

If we assume that markets are sensible, the bottom line is that stockholders in company A won't gain from the increase in earnings per share, because the P/E ratio will drop proportionately (because it's a fair value acquisition). In other words, there were good reasons why company B traded at a low P/E ratio -- low growth, high risk, and low return on equity are three that come to mind -- and company A is now saddled with those same disadvantages. If it can change those parameters, it can gain in value, but that has nothing to do with accretive or dilutive earnings per share.

You may accuse me of being a believer in efficient markets at this point and argue that markets make mistakes. True, it is possible that the acquiring company, at least initially, may be able to fool investors, especially if it focuses on buying small, low-profile, high-risk companies that have low P/E ratios. But ultimately, the truth will prevail. As an investor, you have to ask yourself whether you want to risk riding the ignorance bandwagon as a high-P/E-ratio company grows by acquiring low-P/E-ratio companies, using the accretion argument. If you decide to take the risk, remember the disasters and disappointments waiting down the line for acquisitive companies with high P/E ratios in the late 1990s, such as Lucent (NYSE: LU), JDS Uniphase (Nasdaq: JDSU), Ariba (Nasdaq: ARBA), and Cisco (Nasdaq: CSCO).

The bottom line is that it makes no difference whether an acquisition is accretive or dilutive. Debating the effects on earnings per share is a distraction. What should really matter to investors is whether the price paid on an acquisition is less than the value received in exchange.

This article is the first of a two-part series.

Fool contributor Aswath Damodaran is a professor of finance at the Stern School of Business at New York University. Professor Damodaran has been voted Professor of the Year by the graduating MBA class five times during his career at NYU. You can visit his website for more information. Among his numerous books, Fools might be interested in Investment Fables and Investment Valuation. Professor Damodaran holds no financial position in any stocks mentioned. The Fool has a disclosure policy.

Can You Smell the Market's Fear?

By Tim Hanson
April 28, 2006

American investors worry about Brazil. Despite the most robust economy in South America, its growth was only 2% annually from 2001 to 2003. There's also currency risk, government regulation, and national debt. Moreover, the recent financial collapse in Argentina has investors wary of investing in the region.

But as a smart investor, you can use this fear to your advantage.

Brazilian bathwater
Embraer is an aerospace company based in San Jose Dos Campos, Brazil. And while it is technically a Brazilian company, approximately 97% of its revenues come from North America and Europe. Customers include Continental , British Airways (NYSE: BAB), and US Airways (NYSE: LCC). The company also happens to be New York University finance professor (and Fool contributor) Aswath Damodaran's best investment ever -- as he told Fool co-founder Tom Gardner in a recent interview.

"Investors," Damodaran explained, "tend to discriminate when it comes to emerging-market companies. When there is a crisis in an emerging market, they dump everything." This includes well-managed and diversified companies like Embraer.

Perceptions of Brazil being what they are, there have been numerous occasions to pick up Embraer shares on the cheap. Just take a look at how many times the stock dropped sharply over the past few years. An investment at the beginning of 2003 would be good for a four-bagger by now -- or greater than 50% annualized returns.

Discriminating investors
But most investors aren't just xenophobic -- they fear anything in crisis. After all, psychologists Daniel Kahneman and Amos Tversky showed in their research just how much it pains human beings to lose money.

Fools can profit by being contrary. While the fears surrounding Brazil may be well-founded, they should not extend to Embraer. As Damodaran said, "They [Embraer] are about as Brazilian as Boeing ."

For another example, think back to 2001, when the stock market was coming down around us. Investors sold off tech stocks indiscriminately -- even the that were well-positioned and smartly operated -- to levels that understated their potential.

For levelheaded investors, the returns across these companies have been pretty good:

Company

Return since Jan. 2, 2002

eBay (Nasdaq: EBAY)

112%

Yahoo! (Nasdaq: YHOO)

253%

Amazon.com (Nasdaq: AMZN)

228%

Symantec (Nasdaq: SYMC)

92%

Adobe Systems (Nasdaq: ADBE)

136%

Foolish bottom line
Most investors fear losing money, and they'll sell off even great stocks when the future looks difficult. You can make money by seeing unfounded fears for what they are, and picking up good companies with clear competitive advantages like eBay at bargain-basement prices.

This is precisely the strategy that Philip Durell uses to help subscribers beat the market at Motley Fool Inside Value. To access all of Philip's research and recommendations free for 30 days, simply click here. There's no obligation to subscribe.

This article was originally published on Jan. 11, 2006. It has been updated.

Tim Hanson does not own shares of any company mentioned. Embraer, eBay, and Amazon.com are Motley Fool Stock Advisor recommendations. No Fool is too cool for disclosure ... and Tim's pretty darn cool.