Contrarian Thinking and the Greater Fool Theory

Here are some questions I’ve gotten from readers in recent weeks.

I own (Company X), and it has gone down 15% since I bought it. Should I sell?

I get versions of this question all the time. For example, I've gotten it recently on  First Data  and  IDEC Pharmaceuticals , two companies we own in the Morningstar StockInvestor Hare Portfolio.

A price decline, in and of itself, is not a reason to sell. Now, if a company’s economic moat or corporate governance has deteriorated, you might want to reconsider your opinion about the stock. But if the price has declined without any material news, you’re being given an opportunity to lower your cost basis. Bill Miller is a master at doing this.

In a previous article, you mentioned something about the price/fair value ratio of all the stocks you cover. Can you elaborate on that?

Sure. Morningstar covers 1,000 stocks, and we’ve been publishing fair value estimates on 500 of these for the past two years. These are calculated by our 35 stock analysts using a proprietary discounted cash flow model developed by Morningstar. We can aggregate this data and come up with some useful insights. For instance, the average price/fair value ratio of all 500 stocks can give us a feel for whether the stock market, as a whole, is fairly valued at any given time.

Currently, the average stock we cover is about 12% overvalued; in other words, the average price/fair value ratio among all our stocks is 1.12. The highest this ratio has been is 1.17, in June 2003. The lowest is 0.79, in July 2002. Below are price/fair value ratios at various times over the past two years:

Average Stock Covered by Morningstar
Date	Price/Fair Value Ratio	S&P 500 Value
09-24-01	0.86	1003
07-23-02	0.79	798
10-11-02	0.82	777
03-11-03	0.88	801
09-30-03	1.10	1003
10-27-03	1.12	1031

Although two years is hardly enough time to draw firm conclusions, it appears that the Morningstar price/fair value ratio is a good indicator of whether the market is "oversold" or not. Whenever the ratio has fallen below 0.9, the market has quickly rebounded. It remains to be seen whether the opposite is true--whether a high ratio (such as today's) is a good predictor of market declines.

I see that you recently purchased  Equifax (EFX) for the Tortoise Portfolio. This company has a debt/equity ratio of 2.8. Isn’t that dangerous? Will the company have to cut its dividend to repay debt?

You can’t just look at a company’s debt/equity ratio to figure out its financial health. What you really want to know is whether the company can pay its liabilities (especially its interest-bearing debt) with the cash flow it generates in an average year. You can figure this out by calculating its free cash flow/interest coverage ratio. When I do that for Equifax, I get a ratio of about 7 to 1. This means Equifax generated 7 times more free cash last year than it needed to service its debt. By that measure, the company’s financial health is fit as a fiddle.

Equifax has repurchased a lot of shares and has often used debt to do so. This has shrunk the firm’s book value, as is always the case when a company with a price/book ratio greater than 1.0 buys back shares.

Why does (Wall Street brokerage firm) give (Company X) a "buy" rating, when you list it as 1 star? Why the discrepancy?

John Kenneth Galbraith, the Harvard economist, once said, "The conventional view serves to protect us from the painful job of thinking." Author and philosopher Eric Hoffer once wrote, "When people are free to do as they please, they usually imitate each other." These statements reflect our thoughts on the subject.

Morningstar’s opinion about a stock often differs from the Wall Street consensus because we try hard not to take the conventional view. Sometimes we end up agreeing with Wall Street about a stock after doing detailed research--not the other way around.

Buffett says Berkshire may never pay a dividend. So to make money, I have to sell the stock to someone else. Isn’t this the "greater fool" theory?

As long as a company can reinvest its cash as well as I can do it myself, I’d rather have the company retain earnings instead of paying them out as a dividend. Over time, this reinvestment will create value, and the intrinsic value (and stock price) of the company will rise. I can’t think of anyone I’d rather have investing my cash for me than Warren Buffett.

That said, it might be time for Berkshire to begin paying a dividend. The company has a lot of excess cash.

A version of this article originally appeared in Morningstar StockInvestor, Morningstar's monthly print newsletter on stock investing. Each month, StockInvestor brings you two exclusive Morningstar Stock Portfolios--The Tortoise and The Hare--as well as bulls vs. bears debates on high-profile stocks, "red flag" stocks to sell, and in-depth commentary on issues affecting the market. Also included is a monthly review of Morningstar's Bellwether 50, a watch list of 50 large companies with wide economic moats. For a risk-free sample issue of StockInvestor call 866-608-9570.