Finding Hidden Value in the Market
Seeking Out Bargains for Your Portfolio
In the past, weve talked about the importance of buying undervalued
stocks and how bear markets can actually be a good thing for your
portfolio. How exactly can you go about searching for these attractive
securities? As with most treasure hunts, you are more likely to be
successful if you first know where to look. These helpful hints will
give you an idea of which stones to turn over first.
Share Price Stagnation
Sometimes, over a span of many years, a business will continue to
grow, generating ever-increasing amounts of cash, repurchasing stock,
paying increased dividends, reducing debt, opening new stores,
expanding production facilities, moving into new markets, etc., while
at the same time its stock price remains stagnate (or even falls).
When this happens, the average and professional investor alike tend to
overlook the company because they become familiar with the trading
range.
Take, for example, Wal-Mart. Over the past five years, the retailing
behemoth has grown sales by over 80%, profits by over 100%, and yet
the stock price has fallen as much as 30% during that timeframe.
Clearly, the valuation picture has changed. An investor that read the
annual report back in 2000 or 2001 might have passed on the security,
deeming it too expensive based on a metric such as the price to
earnings ratio. Today, however, the equation is completely different
despite the stock price, Wal-Mart is, in essence, trading at half its
former price because each share is backed by a larger dividend, twice
the earnings power, more stores, and a bigger infrastructure. Home
Depot is in much the same boat, largely because some Wall Street
analysts question how fast two of the worlds largest companies can
continue to grow before their sheer size slows them down to the rate
of the general economy.
Coca-Cola is another excellent example of this phenomenon. Ten years
ago, in 1996, the stock traded between a range of $36.10 and $54.30
per share. At the time, it had reported earnings per share of $1.40
and paid a cash dividend of $0.50 per share. Corporate per share book
value was $2.48. Last year, the stock traded within a range of $40.30
and $45.30 per share; squarely in the middle of the same area it had
been nearly a decade prior! Yet, despite the stagnate stock price, the
2006 estimates Value Line Investment Survey estimates for earnings per
share stand around $2.16 (a rise of 54%), the cash dividend has more
than doubled to $1.20, book value is expected to have grown to $7.40
per share (a gain of nearly 300%), and the total number of shares
outstanding has actually decreased from 2.481 billion to an estimated
2.355 billion due to the companys share repurchase program.
A Corporate Transformation or Turnaround
Sometimes a fundamental business model or operations of a company can
change so substantially that the business is really an entirely
different entity. Occasionally, when this happens, the markets are
late to the party and alert investors have an opportunity to buy
shares before the crowd catches onto the new game. For years following
its decline from the royal standard of the department store world,
Sears was a really a credit card company in disguise. After its
purchase by Buffett Partners in the 1960s, Berkshire Hathaway slowly
became less and less of a textile company until it eventually grew
into one of the largest and most profitable conglomerates in the world
with nary a textile operation to be found.
Another good example, Wells Fargo has transformed itself from a bank
into a financial services company. Following the acquisition of Strong
Financial, the corporation is now one of the top twenty mutual fund
companies in the United States. In addition to the traditional banking
products offered by your corner S&L of yesteryear, WFC also boasts a
robust product offering that includes venture capital financing, cash
management, payroll services, merchant processing, mezzanine
financing, international trade facilities, foreign exchange services,
insurance brokerage, and real estate brokerage. As a result, earnings
arent as inextricably tied to the yield curve as is the case at more
traditional banks, providing the shareholders a better chance at
growth through fee and service revenue regardless of the general
economic outlook.
More Tips for Finding Hidden Value in the Market
Before you can see a transformation on the horizon, it is vital that
you understand the true source of a companys earnings (e.g., from an
investment standpoint, Google is not a search engine; its an online
advertising agency with prime virtual real estate that happens to be
driven by search). Sara Lee, for example, is in the middle of a
massive, sweeping restructuring program. If management executes well,
the new company will be a fraction of its former size with less debt,
fewer shares outstanding, and a core group of businesses upon which it
can focus. At the end of the day, however, critics maintain that the
source of the companys earnings will remain the commodity-like,
low-margin, fiercely competitive packaged foods business; although the
company may be in better shape for the future, it hasnt fundamentally
changed its long-term prospects as its prosperity is still tied to a
business growing in the low single-digits.Nevertheless, this can still
represent a big opportunity for astute investors; in addition to the
rich dividend yield, Sara Lee spun off Coach, a designer and retailer
of luxury handbags, several years ago. Since that time, Coach shares
have appreciated over 1,000%.
Management Change
Assuming youve paid a rational price, the quality of management can
have a massive impact upon the returns you, as an investor, earn on
your stocks. Typically, managerial talent should be evaluated on two
separate fronts: executive and capital allocation.
Execution At the end of the day, how good of an operator is the
executive? Going with some of the companies weve already discussed,
Sam Walton was a retailing genius. His ability to be a first-rate
operator is what brought his enterprise to the forefront of the
American commercial scene. Likewise, Roberto Goizueta was a brilliant
manager that caused shareholders of Coca-Cola to grow very, very rich
during his tenure as CEO. In other words: can they figure out how to
sell the widget better, faster, or cheaper? Can they improve customer
satisfaction? Can they take profitable business from competitors by
executing well in the market place, day in and day out?
Capital Allocation Every dollar of capital is unbelievably precious.
CEOs who realize this basic truth are much more likely to generate
market-beating returns. Imagine you owned a business with a 15% return
on equity that retains all of its profits for expansion. The business
isnt particularly glamorous, nor is it loved by Wall Street. Over the
next fifty years, every dollar you dont spend today on unessential
items such as gold-plated executive washrooms and Persian carpets will
result in $1,084 more capital. Assuming it earns the same rate of
return as the core business, that is $162.60 additional profit in the
terminal year. For a business valued at the median price to earnings
ratio of the S&P 500, the additional profit would add $3,252 to market
capitalization.
Put another way: If the CEO could figure out how to generate one-time
savings of $100K by cutting costs, his company will increase its
market capitalization by $325.2 million in fifty years. Tom Murphy,
famed former CEO of Capital Cities (merged with ABC, then later with
the Walt Disney Company), understood this principle. Legend has it
that he once ordered his subordinates to paint only the front and
sides of his headquarters so he could save the expense on the back
half of the facility.
How can you apply this to your investments? If the CEO of a company is
taking precious capital and using it to chase after empire-building,
low-return acquisitions (e.g., Hewlett Packards disastrous merger with
Compaq, the Time Warner and AOL combination, or Gillettes purchase of
Duracell batteries) run for the hills. Unfortunately, even the best
businesses arent immune from poor allocation; many, many decades ago,
Coca-Cola was actually involved in shrimp farming.
If you know of a company that has been plagued by either poor
operators or bad capital allocation decisions, you may want to pay
attention if a change in management is announced. In most fields with
decent business models, a good executive can mean the difference
between mediocre and spectacular returns.
Final Tips for Finding Undervalued Stocks
Keep in mind that these are just ideas for places where you can begin
to seek for value. Sometimes, a stock is cheap because it deserves to
be cheap - either the business model is falling apart or the
management is unethical.
