When something is going wrong…(ll) value stock problems

As I’ve written in other posts, I’m a growth stock investor.

My initial training and close to my first decade of work were as a value investor, though, and I’ve worked for long periods in organizations where the majority of the senior portfolio managers had a value orientation.  So I do know something about how value works.  Still, I have a much more intimate acquaintance with how growth stock investors go wrong by making the mistakes myself.  In contrast, I’ve learned at least some of how value can go wrong at second hand, by watching others make them.

Having warned you about the state of my knowledge of value, here goes:

Having an investment plan for each stock is important

When you buy any stock, value or growth, you should have a plan for what you expect to achieve from owning it.  Ideally, you will have

–a concept, backed by

–an earnings model that incorporates information that you’ve gotten by researching the company, its products and its industry (10-k filings and annual reports are key here) that give you

–the expectation of substantial gain.

Your plan should give you a catalog of your major assumptions, as well as a roadmap to what good things you expect to happen, in what sequence, and what effect (at least qualitatively) they will have on the stock.

It’s your checklist to diagnose what may be going wrong

The plan will give you your ultimate exit strategy if things go right.  It gives you a checklist to go over–and decide if your assumptions are still valid–if the stock doesn’t perform the way you want.

In my experience, it may take a year or more before you’ve filled in all the details of your plan and feel comfortable that you know a company’s management, be satisfied that it is competent, and are able to anticipate how it will act.

By the way, no professional I’m aware of waits until the plan is completed before buying the stock.  Professionals, myself included, may do a week of research to get the plan structure right and spend the rest of the time putting flesh on the bones.  With a good stock, evidence mounts that you’ve made the right decision.  With a bad stock, the opposite (hopefully) happens.

What makes a value stock

Value investors argue that their stocks are attractive because the stock market does not fully appreciate the value of the underlying companies as they exist today.  (This is in contrast to growth investors, who believe their companies are attractive because the market underestimates the extent or duration of the firms’ future profit growth.)

Why should value stocks be misunderstood?

–Often, investors have an excessive negative emotional reaction to temporary difficulties.  A company may be highly exposed to the business cycle, for example, and investors rush to sell as the cycle turns down, without any thought to the possibility that conditions will someday get better.  We don’t have to go that far back in history–just to last March– to see this idea in action.

–A company may have good products, a great brand name and state-of-the-art production facilities, but weak management that fails to earn the profits the company should make.

–Or the industry it’s in may be hard to understand.

–Or it may be overlooked because it is only growing slowly.

–Or a firm may have had a damaging product recall or made a tactical marketing mistake that Wall Street has overreacted to.

Buy assets at 30¢ on the dollar and sell them at 70¢

The four essential elements of a value plan are:

–calculation of the “true” or “intrinsic” value of a firm,

–determining that the current price is at a steep discount to that number, and

–fixing a target price, and target timeframe, to sell the stock at.

Some deep value investors stop there.  They typically run computer screens to find the cheapest stocks based on price/cash flow or price/book value and buy them.   They argue that the moments of greatest despair are the ultimate buying points for stocks, both individually and as an asset class (think March 2009 again).  They also think that incompetently managed companies that refuse to change will be taken over.

Others want to identify a fourth factor–a catalyst for change–that will start the process of reevaluation along–anything from an uptick in the business cycle to a change in company management.  Personally, I’m much more comfortable with this approach.

Typical problems

a.  getting the intrinsic value wrong

This happens less often than you’d think.  This comes primarily (in my limited experience) from  non-specialists getting involved in industries that are highly regulated, like utilities, or that have no growth prospects, like traditional airlines.  In these instances, the cash flow the firms currently generate is immediately consumed in spending that’s necessary for the firm to survive.  Relying solely on book value as a measure of worth can also be dangerous, since auditors are not always as diligent as they should be in getting their clients to write down assets to true market value.

b.  the catalyst doesn’t catalyze

Think GM.  At one time the company had an unbelievable market position.  It was an American icon and a bellwether of the overall US economy.  It began to steadily lose market share when foreign competition arrived in the US auto market.  Managers developed internally were unable to reverse the company’s fortunes.  The board of directors was equally inept, and also stubbornly resisted advances from outside parties trying to (for a profit of course) be agents of change.

HPQ is another interesting case.  Here the board realized that a once high-tech company had slipped into mid-tech and decided to bring in a high-profile outside manager to turn things around.  Unfortunately, the company chose a marketing executive from ATT, Carly Fiorina, whose greatest talent, from where I sit, lay in marketing herself.  She was fired after several unproductive years and replaced by another outsider, Mark Hurd, who had a strong reputation as an operating manager and cost-cutter at NCR.

Under Hurd, HPQ became an illustration of a value stock that worked, far outpacing the market performance as he reorganized the company.

c.  staying after the party’s over

Value stocks are by and large, mediocre companies behaving badly.  While a turnaround is underway, a firm’s profits may skyrocket and its reputation on Wall Street may soar as well.   But there’s only so much that even the best managers can do.  Once margins have improved to industry-leading standards, growth may decelerate to not much faster than overall GDP.  Once the market realizes this, the stock may being to languish.

By that time, however, the value investor should be long gone.  His calculation is probably something like:  this company is earning $2 a share and trading at 10x eps.  If the company could raise its operating margins to the level of the best firms in the industry, it could be earning $5 a share on the same revenue base and with the existing plant and equipment–and trading at 12x eps.  In other words, if the favorable case plays out, the stock will rise from $20 to $60.

If the $60 price, or some other high value occurs, it will likely happen in year two of a three-year turnaround program–in other words, far in advance of the actual $5 earnings number.  By that time, the market will likely be realizing that the period of earnings acceleration is over and the stock may actually be going down.

Business cycle-sensitive stocks tend to exhibit this pattern.  The value investor judges, based on past cycles, that the stock will peak at, say 10x, peak earnings for the cycle.  Even though the earnings peak may be in year three of the cycle, the stock price peak can occur a year or more earlier.

In this cycle, though, commodity stocks may be an exception to this rule.  Demand from emerging markets and dollar decline may give them more life than an analysis of past cycles would suggest.

An aside:  mechanical rules

Some investors use rules like, “If the stock drops 15% below my purchase price, I’ll automatically sell it.”  or, “If the stock rises 50% above my cost, I’ll take a partial profit.”  Personally, I don’t like rules like this. If the stock’s price action is unfavorable, implicitly telling me I’m making a mistake, I’d prefer to be able to identify the mistake I’m making before acting.

This is at least partly because I’m a growth investor, looking for the next GOOG or AAPL.  My performance tends to be determined by having a small number of very good stocks, so I worry about being shaken out of a long-term winner by a bumpy ride along the way.

Value investors, on the other hand, tend to operate with much clearer, and shorter, timeframes, and with much more easily definable price targets.  So these kinds of rules tend to work better.  As with everything else, you should experiment to see what works for you.

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