It is usually in economic times like these, where earnings are generally poor, that managements will incur asset write-downs and/or restructuring charges. This phenomenon is known as the "big bath". When earnings are negative, a further reduction in current earnings changes little in the way of currently non-existent management bonuses, but sets the company up for artificial earnings gains later, when bigger and better bonuses are to be had as a result.

A simple example presents itself in the form of the acceleration of an asset's depreciation. By writing said asset down now, earnings become more negative, but in the future this asset no longer needs to be depreciated to the same extent, resulting in an artificial earnings boost in the future.

DryClean USA (DCU), soon to be known as EnviroStar (EVI), is a distributor of laundry equipment. This is a tiny company, with a market cap of just $7 million. But for value investors who simply focus on buying businesses that trade at discounts to their intrinsic values (instead of trying to apply small-cap or illiquidity discounts), some of this company's numbers are appealing.

The company's market cap is not much higher than its net cash position of $6 million. Often, a stock with a high cash to market cap ratio is one that is a perennial money-loser. But not in this case. Operating income over the last 7 years stands above the company's current market cap. Demand for heavy-duty equipment has of course waned through this recession, but there are two important attributes of this company that reduce its risk: its customers and its suppliers.

Investors should be aware that certain stakeholders of financial statements can exert pressure or political influence that results in accounting rules that distort the true economic picture of a business. Investors need to be aware that such situations exist so that they ensure they have made adjustments that reverse these distortions.

For example, it took many years before officials finally caved and made stock option expensing mandatory. Managements, fearing that they would have to lower the number of options they receive or face huge drops in their reported profits, lobbied hard against the move. This quote is attributed to Harvey Golub, former Chairman and CEO of American Express:

As value investors, we often foray into areas of investment that nobody else will. Current earnings may be poor, the outlook uncertain, and the returns not expected for several years. In return for these sacrifices, we require one attribute on which we are unwilling to compromise: A large margin of safety.

We are not interested in 10% off or even 20% off, because in the aggregate that does not give us adequate upside for our efforts. Our valuations could be off by such figures, or an adverse event affecting the company could reduce its value by the same.

On my site, we have at times made fun of the findings of various stock market analysts. In the book Managing Investment Portfolios: A Dynamic Process, the esteemed authors discuss some of the traps analysts fall into when making their forecasts.

1) Anchoring trap. The mind gives a disproportionate amount of weight to the first information received on a topic. Keeping an open mind and avoiding premature conclusions is a way to avoid this trap.

Recently, Berkshire (BRK.A) filed its mandatory disclosures detailing its positions in various securities. As a result, you will undoubtedly see headlines beginning "Buffett Buys X Stock" and "Buffett Sells Y Stock". And when word gets out that Buffett has bought a particular stock, its shares jump immediately. After all, if the Oracle of Omaha wants into a company, surely it has a bright future, right? Unfortunately, determining whether Buffett has actually bought a company is not so easy.

Buffett is not the only portfolio manager at Berkshire. But don't take my word for it, as this statement comes from Buffett himself:

It's common to hear that the housing industry is in a depression, and that this type of collapse is unprecedented in American history. When one looks at house prices, which we did here, one can see why. There was a huge run-up in prices, and a huge collapse as a result. Those who bought in at the height of the market are suffering now. But for the housing industry itself, the construction pattern is actually very familiar. Here's a look at U.S. housing completions since 1968 (note that 2009 is an estimate through September):

Click to enlarge:

Imation (IMN) is a 1996 spin-off of the innovative 3M Company (MMM) that produces storage media from DVDs to backup tapes. It owns the #1 brand/sales position in many of the segments in which it competes. Unfortunately, it doesn't generate returns on equity anywhere near 3M, but on the other hand it doesn't trade at a massive premium to its book value either. Imation has equity of over $900 million but trades for just over $300 million.

With some noted exceptions, companies trading with such low price to book ratios are not likely to be profitable or they wouldn't trade at such low levels. Imation is no anomaly in this regard. Due to various restructuring, pension, asset impairment and litigation charges, along with the current recession, Imation hasn't been profitable for the better part of three years. But last quarter, even including the charges, Imation managed to eke out a small profit, which could suggest they are making progress in aligning costs with revenues.

Joel Greenblatt, the book's author, is a value investor extraordinaire and a professor at Columbia's business school. In the book, Greenblatt discusses and justifies the "Magic Formula", a stock selection method that allows individual investors to beat the market using value investing.

Click here for summaries of chapters 1-7, 8-11, 12 & 13

A company that makes for a good investment for one value investor does not necessarily make for a good investment for another value investor. How can this be? A company may appear cheap on an earnings or asset basis, but future earnings may not live up to current earnings and assets may be written down. Therefore, only when a company falls within an investor's circle of competence can he ascertain whether a stock is trading at a discount.

Consider ADDvantage Technologies (AEY), a hardware provider for the cable television industry. The company is cheap on many metrics, trading near its net current asset value with a P/B of 0.75 and a P/E of 6. Though sales have fallen dramatically through this downturn, the company has maintained profitability.

As the market has risen throughout most of this year, many market observers have noted that P/E values are looking rather inflated from a historical standpoint. But of course, earnings are lower than usual this year due to reduced revenue that was caused by financial shocks. So as investors, should we be willing to pay a higher P/E for now, on the assumption that earnings will soon pick up?

When considering the market in the aggregate, this is a very difficult question to answer. Some companies will have cost structures that prove too rigid, and will therefore be unable to adapt to a lower revenue environment. Other companies, on the other hand, will have flexible cost structures or will see revenue continue to grow, despite the downturn. But to determine which of these forces will exert more pull on the market's earnings in the coming quarters is not only extremely difficult, but unnecessary: Unless you're trying to value the entire index, you don't have to answer this question for the market in the aggregate. Instead, you can try to answer this question for individual securities, which are much easier to understand.

Contrary to popular belief, increases in aggregate spending (e.g. consumer spending) is not what leads us to a higher standard of living. Nevertheless, both in good times and bad, consumer spending is the gauge the media focuses on as a barometer of how we're doing; but consumer spending is only a measure of short-term demand. Increases in standard of living, however, come from our ability to do our jobs more efficiently.

For example, consider a plant that employs 1000 workers and makes one widget per day. Suppose one day the plant manager comes up with a new method of making that widget, and only requires 500 workers to do it. The remaining workers just got richer, because now the revenue from the widgets sold is spread over fewer workers. (In practice, of course, this process would take time, and the higher profits would be shared among owners and laborers through market forces. Furthermore, the 500 laid off workers would undergo short-term difficulties until they could join a company that's expanding.)

Joel Greenblatt, the book's author, is a value investor extraordinaire and a professor at Columbia's business school. In the book, Greenblatt discusses and justifies the "Magic Formula", a stock selection method that allows individual investors to beat the market using value investing.

Chapter 12: Choosing a broker/fund manager

When Circuit City declared bankruptcy near the beginning of the recession, opportunities were created for other electronics retailers. One company that aggressively stepped forward to fill the void is Conn's Inc. (CONN), a home appliance and electronics retailer. Conn's even took over some of Circuit City's previous locations on its quest of aggressively growing its market share.

We looked here at the Dow Jones Industrial Average, and saw why it's not a great measure of U.S. stock performance, despite being a favourite index when it comes to media coverage. The S&P 500 is a much better barometer for the health of U.S. stocks, though an understanding of its calculation methodology is important in order to understand the limits to its usefulness.

The S&P 500 is essentially a market-value weighted index*, meaning a company's influence on the index is proportional to its size. This is much different than how the Dow Jones Industrial Average is calculated. Also unlike the Dow, the 500 stocks that comprise the index are chosen such that the index proportionally represents the economy's various industries. As such, the S&P 500 is not just the 500 largest companies. One interesting note is that despite being larger than almost every company in the index, Berkshire Hathaway (BRK.A) is not a component of the S&P 500.

At times, value investing can feel like trading. While value investors should always purchase with the expectation that a stock will be a long-term holding, some stocks can be so volatile that they go from offering a margin of safety to offering a reasonable price and back again within the span of a few weeks! And as Warren Buffett told us when we met with him last year, volatility (shunned as an undesired property by the mainstream finance industry) is the friend of the value investor.

For example, earlier this month we discussed how LCA Vision (LCAV) may have appreciated to a conservative estimate of its intrinsic value. But just three weeks following that article, its price had fallen by 40%, offering investors the opportunity to buy back in at depressed values!