Don't Draft the All-Stars

At Morningstar, we're big fans of ignoring hype and going against the grain. Which is perhaps why Moneyball, Michael Lewis' book about how the Oakland A's managed to win so many games despite having one of the lowest payrolls in baseball, is one of my favorite investing books of the past few years. Though the book is technically about baseball, the larger theme of the story is that conventional wisdom is often just plain wrong.

For those of you who missed the book, the basic story is this: The Oakland A's drafted or traded for players with undervalued skills (walks, on-base percentage, control of the strike zone), while avoiding or trading away players with overvalued skills (running speed, pitching speed, base-stealing ability). By looking for consistent but decidedly unflashy players that other teams had overlooked, A's general manager Billy Beane was able to build a team that won more games than many teams chock-full of superstar players.

While the obvious investing lesson is simple--you’re generally better off going against the grain than following the crowd--there's more to be gleaned from the success of the Oakland A's. After all, Beane bought undervalued traits of baseball players and sold or avoided overvalued traits, and we can do the same thing in the stock market. So, in the spirit of building your own set of winning investing skills, I've compiled a list of company traits and investing practices that I think are "undervalued" and "overvalued." Since the heart of investing successfully is finding inefficiencies in the market, you'd be better off seeking out the undervalued traits and practices--the ones that most people ignore--and avoiding the overvalued or popular ones.  

Overvalued: Acquisition-Fed Growth
Undervalued: Internally Generated Growth
Wall Street loves acquisitions because they generate headlines and investment-banking fees. Unfortunately, acquisitions fail to add economic value more often than not, so look for companies with a quiet, solid record of growing through their own efforts.

Overvalued: IPOs
Undervalued: Spin-Offs 
Initial public offerings, or IPOs, are sold to the highest bidder amidst a slew of hype and propaganda, while spin-offs quietly come to market when a parent firm casts off its unwanted progeny. Which do you think has a longer track record for investors? Hint: It's the one that nobody wants initially, not the one that everyone clamors for.

Overvalued: Well-Known Firms in Big Industries
Undervalued: Leaders in Niche Industries
This inefficiency stems from the industry-oriented way research is done on Wall Street. In order to do a good job researching a company like  Cintas (CTAS) or  Moody's  (MCO), an analyst has to go out and learn the dynamics of a brand-new industry. Since there are few other public players in niche industries, all that new research results in just one more stock on his or her coverage list. On the other hand, an analyst who becomes an expert on semiconductors or retailing can leverage that industry knowledge into a lot more companies. So, small and offbeat industries aren’t as well followed, which means more opportunity for those willing to do some digging. (For example, Moody's and Cintas are each followed by about 10 or 12 Wall Street analysts, while  Advanced Micro Devices (AMD)--whose shares are the same place they were 20 years ago--has 28 analysts tracking its every move.)

Overvalued: What the Stock Has Done
Undervalued: What the Company Is Likely to Do
The market tends to chase hot stocks up, and run away from dogs when they're sinking. However, the recent short-term performance of a stock has absolutely no bearing on the future long-term performance of a company. If you ignore what the stock chart looks like over the past few months and spend your time thinking about whether the company is still healthy, you'll be a better investor.

Overvalued: What Everyone Else Is Doing
Undervalued: Common Sense
Humans are social creatures, and so we often look for "validation." We like knowing that others agree with our course of action, because then we don't feel quite so stupid if what we do turns out to be wrong. Unfortunately, being able to blame everyone else doesn’t make a financial loss go away. So, when common sense tells you that a stock or industry is priced for perfection or is too cheap to pass up, don't worry about what the crowd is saying. Listen to yourself, because you’re the one making the investment.

Overvalued: Retained Earnings
Undervalued: Dividends and Share Repurchases
There's nothing wrong with a company hanging on to its earnings and plowing them back into the business; in fact, that's exactly what you want a company with lots of great internal investment opportunities to do. But companies often plow money into dubious projects rather than returning it to shareholders. In fact, there's some academic evidence that companies with high dividend payout ratios actually have higher subsequent earnings growth than companies that retain lots of their earnings, which is exactly the opposite of what conventional wisdom would have expected. Moreover, last year's tax cut on dividends has made dividend-paying stocks even more attractive.

Overvalued: Flashy Businesses that Sound Exciting
Undervalued: Steady Businesses with Wide Economic Moats
It's easy to get worked up over a company that unravels the human genome or invents a great electronic gadget, but firms like these turn out to be flashes in the pan more often than not. Over time, companies with strong competitive advantages--or wide economic moats--tend to outperform stocks with weak competitive advantages, no matter how boring their businesses might be. Long-term stock performance is tied to high returns on capital, not headline-grabbing products or services. So avoid the flash and go for the cash.

A version of this article appeared Dec. 31, 2003.