What Cinderella Can Teach You About Story Stocks With Happy Endings

happyendingRemember the story of Cinderella? And how she seemed plain and peasantly? With the help of her fairy godmother, Cinderella was able to turn her pumpkin, mice, rat, and lizards into her coach, horses, coachman, and footmen.

You know how that turned out.  Cinderella became a princess, even though her step-mother and step-sisters thought she was destined to scrub floors ’til the end of her days.

To find a story stock worth investing in, you’ve got to search for your own Cinderella:   A story worth believing in, but which is ignored or looked down upon by most other people.

The problem is, most people end up stumbling onto story stocks that have ugly endings, and there are clear psychological reasons why this is so.

But when a story stock is off the radar screen or openly shunned by other investors, it may be selling at bargain basement prices.  If it is, and there is potential behind it that others just can’t see, you may have found your own Cinderella.

Let’s look at one of the most outstanding examples of a true story stock.

The rich man and the newspaper

Warren Buffett started his business and investing career by delivering newspapers and investing the profits into stocks he researched on his own.

He was only 13.

Among the papers Buffett delivered was The Washington Post.  Perhaps it was this childhood connection with the Post which eventually led him into trying to convince its owner Kathryn Graham to buy the New Yorker, of which Buffett had a small stake by 1971.  The deal fell through, but Buffett’s fascination with The Washington Post Company did not.

Two years later, the total stock market capitalization of the company stood at $80 million, but Buffett’s conservative estimate of its intrinsic value was $400 million.

It was as if he had stumbled onto his own Cinderella, one known by many but shunned by most.  Seeing that he had his eyes on a story stock selling at a bargain price, Buffett bought $10.6 million in stock over several months time in early 1973.

As of the end of financial year 2008, the value of that $10.6 million investment had grown to $676 million, a return of over 60 times, and a true fairy tale ending to a story stock.

But I’m not Warren Buffett…

And you’re right.  None of us are.

That’s why you need to learn the lessons that he has ingrained in him.  Like not trusting all of the story elements about a company nearly as much as he trusts hard numbers.

You need to analyze stocks exactly like a true value investor would, which is what Buffett learned from his mentor Benjamin Graham.

Don’t worry, I won’t leave you hanging and never teach you how to invest like the best value investors, but it’s going to take more than a few short words to do so, and this article is already longer than you’d like.

For now, remember that humans have a tragic tendency:  The more we know about a stock, the more likely we are to believe in it having a happy ending, even though our accuracy in picking winners doesn’t go up at all.

That’s why you need to stay away from most story stocks, they usually have bad endings.

The true happy endings are to be found through value investing and an in depth understanding of bubbles and their causes.

But for now, let’s look at another lesson from the story of Cinderella, so that you’ll be more likely to find a story stock with a happy ending.

A surprising ending

Everyone was surprised when they found out who the girl with the glass slipper really was.  Everyone except you, of course.

Putting things a little more crudely, Cinderella’s value shot through the roof when she put on the abandoned glass slipper.  Her true value had gone way up.

Imagine if it hadn’t been Cinderella’s slipper, but instead belonged to the girl that everyone in the town thought was the prettiest.  Very few people would have been surprised, and the value of the pretty girl in others’ eyes would have only gone up a smudge.

Well, the same is true of stocks.  As one of the most famous value investors out there, David Dremen, puts it:

Earnings surprises have a consistent and predictable effect on stock prices.  More to the point, their impact on stocks that people like is dramatically different from their impact on stocks they don’t like.  Understanding the nature of surprises provides a high-probability method of beating the market. ¹

A mouthful, right?  But David would recognize the parallel with the Cinderella story right away:  Undervalued stocks, like Cinderella, see their worth shoot up very quickly when met with unexpected but good surprises.

And the opposite is true as well.  Story stocks, at least the ones that everyone love, plummet in value when a bad surprise reveals itself.

Up is down, and down is up

Let’s put this in real terms.  Dremen looked at the effect of earnings surprises on stock prices.  That is, when a company came in below or above analyst’s earnings estimates for a financial quarter, by as little as one cent.²

What he found was fascinating.  Stocks that were unloved by the market, ranked in the bottom 1/5 of stocks measured by their price to earnings ratio, shot up in price when they had positive earnings surprises, rising 3.6% over the market return in the same quarter and 8.1% for the full year.

And these Cinderella-like stocks didn’t see their values fall much if at all with negative earnings surprises.  After all, no one in Cinderella’s town would have been surprised if the glass slipper hadn’t fit.

On the other foot, the counterpart to Cinderella stocks, ranked in the top 1/5 of stocks measured by their price to earnings ratio, plummeted in price when they had negative earnings surprises, falling 4.3% below the market return for the quarter and 8.9% for the year.

By now you should easily be able to guess that a positive earnings surprise had almost no effect on the value of these favored stocks.   Just like if it hadn’t been Cinderella who fit the glass slipper but the town beauty, the value of these stocks stayed mostly the same after a positive surprise.

Getting to your own happy ending

If you want to find a real story stock, you need to look where nobody else is looking.

After all, that’s how Cinderella was found, and it’s your best way of getting to your own happy ending.  So long as you subscribe to Happily Ever After Investing, that is =)

¹ David Dreman, Contrarian Investment Strategies For The Next Generation (New York: Simon & Schuster, 1998), page 118
² Ibid., pages 125-128

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