Folks – as you can imagine, I have been busy ripping through annual reports and financial statements like crazy. Hence the irregularity to my posting. Back in October of last year, I had a lot of time on my hands – the effects of a high market and few opportunities. That situation has reversed.
What am I looking for? The economy has been putting a squeeze on a lot of companies, slamming profit margins, revenues and earnings. When this happens, companies have to start shedding assets – human and physical – in an effort to return to normal levels of profitability. When profit margins are thin, the business’ are at risk (think GM, Blockbuster). When profit margins are fat under normal conditions, the business is sound, even if it takes a substantial hit to sales.
So-called “bottom feeding” is the art of finding deeply discounted businesses that have a high probability of returning to “normal” conditions (ie., normal profit margins, normal owner’s margins) when the dust settles. That’s where you will find tomorrow’s winners. (Note: This is also why quality of management and high owner’s margins are so important. Bad management won’t know what to do; thin profit margins can be too tough to overcome.)
It’s far easier to tell what will happen than when it will happen.
Today’s markets are a test of all the value investing reading, studying, and learning you’ve been doing over the past (days | weeks | months | years). When the markets are on the rise, it’s easy to call yourself a value investor, pick a stock you think is underpriced, and make money. The true test is when the markets drop and you have the conviction to look at a business, figure out its worth under “normal” conditions, put your money to work, and then close your internet browser for a while.
And watch out for bonehead moves. It’s easy to lose sight of the long-term when your portfolio is dropping a few percentage points each week. Don’t play the markets unless you are 100% sure. When the Dow was at 13,000 last month, you could be pretty sure that it had topped out. (If you weren’t sure, forget the rest of this discussion.) At that point, you could have purchased puts on the markets or otherwise taken advantage of some of the irrational exuberance. (The “Phew, that was close. Glad it’s all over.” sentiment on Wall Street.) In May 2008, the Dow 13,000 was way too high – I told a friend not to be surprised to see Dow 11,800. Now at 11,200, I have no idea whether or not we are oversold – I can’t call a bottom nearly as clearly as I can see a top (at which my vision is murky at best).
GM at $10 a share? People are acting stunned. Five months ago, it was a $29 stock. But the threat of bankruptcy – or at least a very severe scaling back – was just as great then as it is today. I tried to short it but the nice people over at TD Ameritrade informed me I couldn’t – that they didn’t have any shares in inventory. (I guess TD Ameritrade clients don’t like GM.) I know I said Don’t Go Short on Overpriced Companies, but the GM play was entirely different. Read on:
When Apple was a $150-$160 company last year, shorting it at $186 would have been very risky – how could you have known whether the price would remain flat until value caught up or the price would drop to a level more commensurate with value? Shorting Apple, you’re betting on the “when” instead of the “what”. With GM, nothing but a miracle could have helped the business. In this case, I wasn’t betting that GM’s price would fall (the “when”); I was betting that GM’s business would fall (the “what”). The price would eventually follow the value – in this case, practically none. (It’s very similar to Ken Heebner’s shorting of Countrywide last year in the high $40s.)
What’s the point? Find what Wall Street calls “Fallen Angels” – great businesses that have fallen in price due to some temporary disruption, but that should return to profitability or “normalcy” in the next few months and years. Keep an eye out for “Falling Knifes” – businesses that are suffering (or are expected to suffer) so greatly that recovery is contingent on miracles or a very severe scaling back. Bet on what you know will happen; don’t worry about the when.
To those of you whom have asked for the “owner earnings vs. free cash flow” email, I’ll get it to tomorrow. Sorry for the delay; I just found it again last night.
Filed under: How to Think About Investing
Im seeing plenty of opportunities since the credit crunch and companies such as MHP, WFC, Moody’s look like some companies to look into at their current price. I thought it would be interesting to compare their prices(july 08) to where they could be whenever the “dust settles”.
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When Buffet bought BAC a while back when it was selling in the 50s, I took notice. When the stock fell to $37 I was tempted, but couldn’t pull the trigger. I’ve been salivating over both BAC and WFC ever since, but even at the low 20s I just can’t seem to do it. The thing is, I’m either passing on the Horn of Plenty or Pandora’s Box, if only I could figure out which.
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You claim to be a value investor that looks for companies he could in theory hold “forever” (i.e. a buy-and-hold investor). Yet you talk about shorting stocks and engaging in work-outs, which are speculative market plays more in-line with a trader mentality. So which are you? A wolf in sheep’s clothing?
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joe: When you are watching the news and markets all day, you can become somewhat attuned to the market extremes. The Dow was 13,000 and the talking heads were rejoicing that the worst was behind us and that we were on the brink of a turnaround. In my view, we still had some tough times ahead. 13,000 was overly optimistic. 11,800 seemed more realistic, but I’m not 100% confident that we are necessarily oversold at 11,200.
BPal: I try to make smart business decisions and look to invest when others are doing foolish things. It’s no different than when Buffett is buying or selling options against the markets or engaging in workouts or arbitrage. 80% of what I do in the stock market is look for underpriced companies that I can hold forever, or at least until price approaches my estimation of value. 40% of what I do is look for opportunities made available by the fear or folly of others.
Read the post again – particularly the paragraph that starts with the discussion of Apple. As a stock trader/speculator, I have proven (to myself) time and time again that I am a miserable failure with absolutely no tolerance for price fluctuations. Because of that, I do not trade or try and profit from short-term fluctuations.
That said, when opportunities arise where people are doing foolish things and I have an opportunity to profit, I don’t think according the name “speculator” is appropriate just because things can happen fast.
What is the difference between going long in an underpriced business and shorting a doomed-to-fail business? Very little. Why would Buffett sell puts against the S&P or I short the DJIA? He bet a small portion of Berkshire’s assets that the markets would move very little or up; I bet a small portion that they would move down. We both made educated gambles based on rational business decisions because we felt that people, as a group, were being foolish.
Make sense?
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Hi Joe,
Thanks for the post. Like you, I rooting around in unloved sectors. I recently did a post on Cheesecake Factory, Inc. on my blog – how do you feel about consumer discretionary in general – and restaurants in particular. Two things I’m worried about. Being (too) early is the same thing as being wrong. And the eventual pricing power that restaurants may have.
Thanks again, and keep posting!
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People are definitely tightening their belts, and that is a good thing. At some point, all of these companies become so cheap that they make sense. CAKE might lose 10% or 20% (or 30%) of its traffic, but it will still have a very loyal following. When the markets are pricing these companies as though they are going away, I’ll buy.
I’m not crazy about restaurants, but I’m not crazy against them. They are just there for me (like most industries). If the company gets cheap enough and it is strong enough, I’ll buy. That said, I would not get as excited over a CAKE as I would if a Coca-Cola type franchise was being given away.
The consumer? The consumer is cutting back, and will likely continue to do so. Still, the companies that can adjust to this, but are priced like they are going away — that’s where we’ll find great opportunities.
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“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to heaven, we were all going direct the other way – in short, the period was so far like the present period, that some of its noisiest authorities insisted on its being received, for good or for evil, in the superlative degree of comparison only.”
It’s the best of times for value investors. I do believe, however, that the best deals you can find today will be better in a few months. I guess that makes me the most foolish of all “investors”, a market timer.
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