Buying Distress and Falling Knives or the “No Hope” Portfolio.
Cloud Peak Energy
Completed 1:14 EST
I am buying a basket of coal miners today with different characteristics. CNX is not a pure coal company. Peabody is more of a stub stock since its market cap is about 1/10th its debt–scary! I will add on a further 25% decline. Holding period: five years. I recommend that anyone reading this NOT follow me. Do your own thinking or mis-thinking as the case may be.
We also don’t want to confuse low nominal prices or declining prices with “cheapness.” There are plenty of junior resource stocks trading for pennies that are worth $0. Microcap_stock_fraud
We skip Chapter Six (for now) and focus on Chapter 7 in DEEP VALUE: Catch a Falling Knife: The Anatomy of a Contrarian Value Strategy
In Search of Un-Excellence
The authors identified 36 publicly traded “excellent companies” on the basis of out-performance in six criteria, measured from 1961 to 1980.
Return on total capital
Return on equity
Return on sales
Market to book value
Then an investment analysts, Michelle Clayman, identified 39 publicly traded “un-excellent companies” which ranked in the bottom third of all Peters and Waterman’s criteria from 1976 to 1980. These “in search of disaster” companies outperformed 24.4% pa over five years vs. 12.7% for the “excellent” companies.
The good companies under-perform because the market overestimates their future growth and future return on equity and, as a result, accords the stocks overvalued price-to-book ratios; the converse is true of the poor companies.
Over time, company results have a tendency to regress to the mean as underlying economic forces attract new entrants to attractive markets and encourage participants to leave low-return businesses. Because of this tendency, companies that have been good performers in the past may prove to be inferior investments, while poor companies frequently provide superior investment returns in the future.”
Note pages 128 to 136 in DEEP VALUE: Tables 7.1 to 7.9
Stocks in the Contrarian Value portfolios were cheaper than the comparable Glamour portfolios on every metric but on a Price-to-Earnings basis, possibly because the earnings in those portfolios were so weak.
First, valuation is more important than growth in constructing portfolios.
Cheap, low growth portfolios systematically outperform expensive, high-growth portfolios, and by wide margins. It seems that the uglier the stock, the better the return, even when the valuations are comparable. Oppenheimer found in a study on Ben Graham Net/Nets that loss making and non-dividend paying net/nets outperform profitable, dividend-paying net/nets. Ben Graham Net Current Asset Values A Performance Update
In almost any study, the cheap, hated, ugly, least-admired, and poorly performing stock outperforms the high-growth, glamour stocks.
What these studies demonstrate is that mean reversion is a pervasive phenomenon, and one that we don’t intuitively recognize. Our untrained instinct is to pursue the glamorous stock, the high-growth stock, the story stock, the excellent stock, the admired stock, the A+ stock, or even the profitable net net, but study after study shows that this instinct leads us to under-perform. Buying well-run companies with good businesses at bargain prices seems to make even more sense. The research shows , however, that the better investment–rather than the better company–the value stock, the scorned, the unexcellent, the Ds, the loss-making net nets. And the better value stock, according to Lakonishok, Shleifer, and Vishny’s research is the low-no-growth value stock, what they describe as “contrarian value,”
What is clear is that value investing in general, and deep value (buying the ugliest of ugly) in particular, is exceedingly behaviorally difficult. It is counter-intuitive and against instinct, which is why many investors shy away from it.
Lecture by Toby Carlisle on Deep Value Investing
We will finish up this chapter by covering The Broken-Leg Problem. Please give this chapter a close study–the conclusions are extremely COUNTER-INTUITIVE and the opposite of what most investors look for. We are at the heart of deep value investing.
This Post is to establish a basis for a case study in the future. This post is NOT a recommendation to do what I do (buy LXK today at $20.71) because you may be doing this:http://www.youtube.com/watch?v=go9uekKOcKM.
When LXK announced earnings, the price plummeted further. What I did not want to do is this: http://www.youtube.com/watch?v=VfiY2nbV9RI&feature=related I don’t want to ignore the market’s reaction. I concluded that LXK’s intrinsic value had declined due to a lowing of future cash flows, but that price had more than compensated for the news. I decided to hold.
But I needed to step back and reflect on the situation and my portfolio’s condition. First, LXK is not a franchise. It’s business allows some customer captivity for reselling toner, but the business is changing/shrinking while the company transitions into more software services where the company may not have a competitive advantage.
Secondly, management announced and is–so far– returning capital to shareholders, so I view this as an asset/special situation type of investment. Though the overall printing market will shrink, it won’t disappear within five years and if the company can buy in shares at lower prices, value will out unless the business is permanently impaired. A more in-depth view/valuation will be forthcoming in another update.
I noted that about 1/4th of the company shares traded hands on the last big sell-off. I don’t know if that indicated capitulation, but I am estimating that the sellers where not the most informed participants. Why wait to sell after the price of the company has dropped by 50% and AFTER the news has been announced twice?
Since I weight special situation/asset investments smaller than franchise (compounding machine) investments, this was about 1% which I could build to 2% or 3%. I may have 20% of my account in my favorite holding. But I won’t buy more because management doesn’t own a significant share of the business, there are impediments for a take-over and I don’t see management buying shares for themselves.
I would sell if I find a more compelling investment for the capital, especially if I could acquire a tax asset (loss) while having the same margin of safety in another investment.
I hold LXK, and I will have another update in due course.
Update Jan 23, 2013. Unfortunately my target has been reached so I have sold around $28 per share my remaining stake. Oh no, cash is building up.