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Stock Ideas Investors Daily Edge The Secret to Bottom Fishing Distressed Stocks
Stock Ideas Investors Daily Edge The Secret to Bottom Fishing Distressed Stocks 
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| All it took was a 9% fall. That's how far the S&P 500 declined from its July peak before the "defensive stock" articles started springing up last week. | |
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| The Secret to Bottom Fishing Distressed Stocks |
| Thursday, 28 August 2008 | ||||||||
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It’s not quite time, but summer is ending. The tallest maple trees are sporting a few red leaves up here in New England. In a couple of months, I will be in the middle of my annual sector review and outlook. It’s a value update. Some people watch sectors rotate. I watch sector valuations (like price to earnings ratios, or P/E) rotate. I do it because I’ve discovered that the coming year’s best investments often arise from the previous year’s most overlooked and undervalued sectors. It doesn’t always work perfectly in its simplest form, though. The most undervalued sectors for 2007 were so-so. However, 2006’s were outstanding sources of hot stocks. Ditto those of 2005 with a cherry on top. The most undervalued sectors at the start of 2008 have been pretty good, too. We’re still in the short term, but of a list of 35 companies I chose from the most undervalued sectors this spring for my annual Rising Tide watch list, 19 have gains and four more are about where they began. In short, two-thirds of the “unloved sector” stocks on my watch list are beating the S&P and showing gains or holding steady this year. In the market at large, only 35% of all stocks are beating the S&P 500’s negative 2.5% performance in the same span. So yes, the Watch List I develop every year from my sector research tends to point the right way. Except once. Why did 2007 do badly? There’s a lesson in it for the coming year… and a big lesson for you right this minute if you’re thinking AIG, Ford and some today’s other beaten down giants can’t go any lower. You probably know by now if you’ve been reading IDE regularly, that in addition to being a value investor, I also am a chart reader. I “get” technical analysis and have no compunction about adding its tools to my value foundation. I do think that charts and prices can tell you things… but one thing they emphatically do not ever say is this: “It can’t go any lower.”
Nor do they say any variation on that theme, such as “this is the cheapest it’s been in five (2, 10, 18, whatever) years; it’s got to go up.” Nothing has to go up. As any chartist knows, until a turnaround has definitely started… until a stock has bottomed and already begun to rise noticeably, there is no telling that it won’t fall farther. The ultimate bottom for every stock is zero. And that includes “too big to fail” giants. That’s why after 2007, I added a tweak to my annual watch list. Because finding beaten-down stocks is only part of the exercise. The easiest part. The trick is finding beaten-down stocks that are showing the potential for company profits. Unless the company has hopes of making money or at least paying you a dividend, its stock is no bargain at any price. “It can’t fall any farther.” “It’s too important to fail” …these are follies. Big companies fail all the time. Just Google “Barings” if you want a spectacular example of a venerable company that went from blue chip to cow chip in record time. If Ford doesn’t sell cars, Toyota will. X number of cars are going to be bought next year, and even the old folks who used to only buy American are driving Hondas, Toyotas and Nissan’s these days. If AIG doesn’t sell you property insurance, ING, State Farm or AXA will. Where there are buyers lined up, competitors will come along and do business. This is how capitalism works. But with stocks like AIG and Ford so far down from their highs, a lot of investors are forgetting the reality of the business behind the stock. They see a cheap share that could make them thousands of dollars climbing back from today’s lows to reach yesterday’s highs again. It’s half of a right idea. What’s to lose? A lot. Maybe everything. If the worst happens, Ford could follow Studebaker. AIG could go the way of American Mutual. It’s good to get a cheap stock, but it’s not a great idea in itself. A great move is getting a terrific company during a bad patch or one that others have underestimated and priced at a discount to its true potential. The key is in knowing the potential. It has zero relationship to a company’s historical share price. Potential, not price, is the metric to follow when you’re tempted to bottom fish. Let’s walk through two contrasting cases. This week, AIG hit an 18-year low. Analysts expect the insurer to earn $4.94 per share next year. Insurance companies tend to command low P/E ratios, between 12 and 17 for property and casualty insurers. Go to the low end. Consider that analysts are too optimistic and figure on $3.40 per share in earnings, a 25% discount. Then take the very lowest historical P/E of 12. That makes AIG worth a theoretical $40.80. At today’s price of $19, it does represent a probable value… if the earnings estimates are even close. The company also has good long-term earnings potential if its derivatives write-downs don’t kill it first. More investigation is needed, but this is certainly worth checking. Now look at Ford. Analysts expect -$1.81 in earnings from Ford this year and -.78 next year. We’ll follow the same procedure—say it’s 25% worse. That’s -$.98 in earnings for 2009. There is no P/E because there are no positive earnings. There’s no dividend anymore, either. What about price to book value, a deal if it’s less than 1.0, right? A decent level might even go to 1.2 times book value per share like Daimler or Honda. The problem is that Ford’s so far in debt, its liabilities outweigh its assets and its book value is negative, too. No prospects of earnings foreseeable, no dividend, outrageous debt, book value under water… what would an investor hope for in Ford? Even Lee Iacocca isn’t that brave. Ford’s stock may be just north of $4, but it’s no bargain. If you want to take a bet on that, you are far braver than I am. You have to believe in magic. Ford is years away from financial health, if it ever gets there. As for a government bailout, the only one I see is one that protects the workers in its shattered pension plans. Somebody may make a killing buying Ford today and reflecting on his coup 10 years from now, but it’s a long shot. Lynn P.S. To let me know what you thought of today's article, send an e-mail to: This e-mail address is being protected from spam bots, you need JavaScript enabled to view it
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