Sunday, June 22, 2008 2 comments ++[ CLICK TO COMMENT ]++

Does It Make Sense To Buy Stocks That Have Fallen Off A Cliff?

Does it make sense to buy beaten-down stocks (say those that have fallen 50%+)? Most traders have a rule that says that one should never buy anything that is falling and hitting 52wk lows. Well, I'm not a trader so I don't follow that rule, but should one still avoid them?

A stock that has fallen 50% would have wiped out 100% of its gains in the past since returns are geometric. For example, a stock appreciating from $5 to $10 results in a 100% gain, but if it falls to $5 then it is a 50% loss from the higher level. Roughly speaking, given that the stock market yields a long-term return of around 10% per year, that means it wipes out around 8 years worth of gains (10% compounded over roughly 8 years = 100%). Although stock price gains do not necessarily match profit growth, one can, in a simplistic sense, think of it as wiping out 8 years worth of company profits. A lot of the financial stocks in America have dropped 50% (or more) and are back to levels in early 2000's. Is it worth investing in them?


Deep Value Investing

One of the main strategies that tries to capitalize on extremely depressed stocks is called deep-value investing. It is essentially extreme contrarian investing. A sub-set is what is called distress investing but not all beaten-down stocks would be considered distress investments (some companies are just out-of-favour and in "ancient" or niche industries--if you don't like companies under storm clouds, you can look at obscure industries that have reliable profits but are ignored for various reasons (possibly because of low growth, smaller size, regional focus (eg. unrecognizable brand names)). I have no idea if I'm cut out for what I'm pursuing these days (I'm trying to figure it out). I remember reading on some message board that deep value investing is the hardest technique out there. Some say it's even harder than momentum investing (momentum investing is also very tough and many studies say it is one of the worst in the long run.)

The biggest problem with going after these beaten-down stocks is that you can end up with massive losses if you are wrong. Any value investor or contrarian investor can end up catching a falling knife or falling into a value trap, but a mistake with these deep-value investments is like falling into a pit filled with spikes. I think it was Buffett who said that most junk bonds are junk and end up almost worthless. Well, I think many of these beaten-down stocks are junk and the underlying companies may end up near-worthless as well.

Another risk with going after beaten-down stocks is that they can fall precipitously--often without any news or change in fundamentals. All it takes is for one unhappy institutional investor to unload and the price gets killed (depending on the size of the market cap.) One just needs to look at a company like Ambac to see how it moves 10% per day with practically no major news (unless you count regurgitating 5-day old news as new). Other companies that I have followed, although not commented on much in this blog, like AbitibiBowater, a distressed forestry company have also seen their stock price drop substancially on some days with seemingly no news.

Criticism of Those Buying Collapsed Stocks

The reason I am writing this is to address Synchro, who challenged the notion of buying stocks that have fallen 70%+ (his comment was a few weeks ago but I just finished writing this up now). I believe his main criticism is towards Bill Miller, who has averaged down into stocks that have fallen substancially. In some cases, Bill Miller already had a position in these companies, while others are brand new. Synchro's skeptical view can also apply to Seth Klarman (a master deep-value investor), Martin Whitman (master distress investor), and others. His view also applies to lesser-mortals like me and ContrarianDutch, who took a position in Ambac a few weeks ago. I have no idea if any of my picks, or any of Bill Miller's for that matter, will work out. So I can't disprove Synchro for any of these stock picks. However, I can try to show why his argument, if blindly applied across the board, fails.

Synchro: When a stock drops 70% ~ 90%, the market's verdict seems pretty definitive. I can understand one "second-guessing" a 20% or 30% drop. There's a pt beyond which it may make sense for one to get serious about whether his own analyisis is objective/rationale or delsuion/wishful thinking.


It's kind of funny but I have the total opposite view from Synchro. That is, if the price drops 20% or 30%, the market may be pricing in fundamentals. But if it drops 70%, the market may be irrational. I'm not saying that is the case for everything but I really believe that the market is far more irrational during stressful times than during normal times. A 20% drop happens during normal times while a 50%+ drop is generally during some stressful period.

Past Examples of Successes

Let's take a look at some classic examples. I mentioned in my response to Synchro's comment that I'll look at Buffett's American Express purchase but I can't find free charts going back to the 1960's so I'll look at few other cases (actually, I can go to the library and scan some chart from an old stock guide but I'm too lazy to do that :) ). Before we get to the charts, I'll point out that I'm cherry-picking the stocks but I think that doesn't detract from my argument given that the whole point of our investing style is to pick stocks not to blindly buy everything that drops 50%.

The point of presenting the charts below is to illustrate that the market can be incorrect even if the price drops 50%+. What Synchro says should be kept in mind but that should not preclude one from investigating individual picks.

(all prices in charts below are split-adjusted so they are not the original prices; Let me know if there are mistakes in my understanding of some price declines (eg. if division was spun off; stock dividend was offered; etc); charts courtesy bigcharts.marketwatch.com)

Washington Post in the 70's

The following chart captures one of Warren Buffett's best investments of all time (on a side note, his #1 investment of all time is GEICO.)



The chart plots Washington Post in the early 70's when newspapers were falling out of favour. In this case, the stock had dropped around 66% from peak to trough. Now does it look like the market is right when prices drop almost 70%?

I'm not as familiar with Warren Buffett's record as some Buffett fans are--and I know many of you are reading this :)--but the beauty of this pick isn't necessarily the returns. Instead, it is a very good investment because the downside was low. Buffett explained that the liquidation value of the firm was much higher than the market price. So even if Washington Post went bankrupt, he would not have lost any money. That is what we should look for whenever we venture into these distressed investments.

Anyone investing in a bond insurer, for example, should try their best to figure out the run-off value. Martin Whitman believes that the run-off value is higher but it's up to you to figure it out. Similarly, anyone investing in Sears Holdings should have a good grasp of its break up value. William Ackman thinks that the asset value is much higher than the stock price but you need to do some work and come up with your own estimate as well.

Citigroup During The Savings & Loans Crisis

Here is a chart of Citigroup during the early 90's:



For those not familiar, the prior real estate collapse was in the late 80's/early 90's and led to the savings & loan crisis. The collapse wasn't widespread since it was limited to select areas, such as Texas, but some companies faced lingering problems. Although some of Citigroup's problems during that time were with commercial real estate loans, the real culprit seems to be the economic recession at that time period (possibly caused by the S&L crisis that was festering.) This is quite similar to the current period in that, the real estate losses being taken by financial firms may be tolerable but if the real estate bust causes a severe recession, the financials could face serious problems in other areas. No one obviously knows what will happen so the tactic followed by investors such as myself is to only invest in financially strong firms. In any case, Citi was facing huge problems as you can tell by the 65% drop in stock price.

One of John Neff's brilliant investments was Citigroup during this turmoil (for those not familiar, John Neff was one of the most successful mutual fund investors in the 70's and 80's and managed (what ended up becoming) the largest mutual fund of that era, Vanguard Windsor.) Citi, like most other financial institutions that survived, went on to be a great investment. If you ever look at long-term charts (most of which are just price-only charts), don't forget to factor in the dividends of these companies. Financials, in particular, have paid fairly good dividends over the years and they seem worse on the charts than they really are.

If the P/E ratio on these charts are accurate, Citi's P/E went below 6 during the crisis. Although P/E ratios can be misleading at times, they do provide a good starting point for beaten-down stocks. It's hard to ignore a company with a P/E of 6 if you think it won't go bankrupt. One other item I want to point out is that the market never placed the same multiple on Citi after it recovered in 1991. Although this is just for the short to medium term, it illustrates why one should not expect P/Es to hit normal levels even if the company recovers. I suspect that if financials get out of the current crisis, the market will price them lower. This is almost a certaintry given that financial companies are deleveraging (lower leverage generally means lower profits.)

Fannie Mae During Savings & Loan Real Estate Crisis



David Dreman has been a fan of Fannie Mae in the past (I think he still likes it now but not sure if he would invest right now.) However, note that David Dreman holds a diversified portfolio so I'm not sure if this was a big bet or just a contrarian pick among the financials (he also invested in a lot of the other regional banks at that time.) Fannie Mae declined around 40% during the S&L crisis. I wasn't investing back then so I'm not entirely sure if the decline was due any fundamental business problems or simply due to the market selling off any bank with real estate exposure.

In any case, Fannie Mae was a spectacular investment. From the bottom in 1990 to the peak in 1998 (or ultimate peak in 2000), it posted around 80%/year in gains (similar to Berkshire Hathaway.) I'm not an investor who thinks about the big upside potential but it's interesting to think about the big run-up in some of these companeis in the booming 90's. I'm not sure how many investors, even Fannie Mae shareholders, thought it could do so well when all the talk was about technology stocks.

Dell In The Mid-90's

Some investors do not consider Bill Miller to be a value investor and his investment in Dell is one of the reasons that is given. The following is a chart of Dell in the mid 90's:



Contrary to a misguided view, value investing does not preclude one from investing in growth stocks. Instead, what distinguishes value investors is their strategy--reasoning. Value investors have picked computer companies in the past but Bill Miller's pick in 1996 was questioned by some. Typically value investors buy stocks that are undervalued. One of the commonly followed theories for cyclical stocks--PC manufacturers were cyclical in the 80's and early 90's--is to buy when P/Es are super-high or infinite (i.e. earnings depressed) and sell when P/Es are low. So most value investors would have bought Dell in the early 90's and sold when they ran-up and hit fair value. Bill Miller bought in 1996 and most value investors who bought around that time would have sold when the price rose substancially. Bill Miller never sold!

Bill Miller didn't sell because he said that Dell was earning high returns on its capital and its business was growing. Bill Miller was overloaded on growth stocks and got clobbered in the 2000-2002 bear market but I agree with his thinking. Someone asked why he he held Dell with P/E of 35 versus Gateway with a P/E of 12 and you can see Bill Miller's strategies in his answer (I recommend this interview to anyone interested in Bill Miller. He may be loathed by some and I wouldn't quite put him in the class of Whitman, Templeton, or Lynch, but he is certainly unique):

(source: Fred W. Frailey "The Fine Art of Value Investing - William Miller of Legg Mason Value Trust - Interview". Kiplinger's Personal Finance Magazine. March 1999. FindArticles.com. 21 Jun. 2008. http://findarticles.com/p/articles/mi_m1318/is_3_53/ai_53893714)

Q: Even though the price-earnings ratios of these tech stocks are soaring in the stratosphere?

Bill Miller: P/E ratios by themselves are irrelevant. They capture one factor in a stock and often have little to do with underlying values. Let me explain my approach this way: Somebody said to me six months ago, how could I own Dell Computer and not Gateway because Gateway is a much better value? I said, what do you mean? Well, he said, Gateway trades at 12 times earnings and Dell trades at 35 times earnings, so Gateway is obviously a better value. So I replied that I had two businesses for him to invest in. In one he could earn a 200% return on his investment. In the other he could earn 40%. Which would he choose? Why, business number one, of course, he said--it's five times as profitable. I said, you just described the difference between Dell and Gateway. Dell earns 200% on its capital and Gateway 40%, yet Dell trades at only three times the P/E ratio of Gateway.

...

Q: Why did you buy Dell and AOL? Those are stocks you never find in a value investor's portfolio.

Bill Miller: AOL never, but lots of value investors bought Dell when it traded at six times earnings. If you look at historical valuations of personal-computer stocks, their prices used to bounce between six and 12 times earnings. When Dell fell to a P/E of six, value investors moved in. When it rose to 12, value investors sold.

Q: Why didn't you sell Dell then?

Bill Miller: Because we analyze businesses, not historic stock-trading patterns. I was surprised to find that Dell was worth four times what we paid for it--that is, when we bought it for $2, adjusted for subsequent stock splits, I figured its real value at $8, based on our analysis of free cash flow and other factors, including a return on capital of 35%. Since then, the company's revenue growth has far exceeded what we projected. And return on capital rose in 18 months from 35% to 229%--the highest in American industry. Now if it was worth four times the $2 we paid, and subsequently became seven times more profitable, you can understand why we kept raising the value of the company. We estimate its value in the low to mid $80s, versus its current price of $75.


Maybe Bill Miller is just a one-trick pony as some suggest but, so far, I'm disinclined to believe that. I actually like his thinking and feel that he has unique skills.

You can see how Miller's strategy differs from a pure value investor such as Seth Klarman. Klarman would never look at half the stuff Miller invests in but in addition to that, Klarman's strategy is to sell when something hits fair value. This is what is followed by most value investors and many other type of investors who venture into beaten-down stocks. In contrast, Miller's strategy is to hold if profitability is still strong. Warren Buffett also holds (eg. Coca-Cola in the late 90's; Washington Post in 2000's; etc) but he is a control investor and likely will suffer reputational damage if he sells.

It's difficult to say if Miller is simply lucky with his Dell investment or if his thinking was bold and unique. Dell certainly resulted in huge gains because it became the #1 PC manufacturer in an industry with super-high growth. So, was Miller simply saved by Dell's unanticipated high growth or is he right in holding companies with high returns on capital?

He doesn't mind holding if growth is strong, even if the stock looks wildly overvalued on many value investing metrics (such as P/E ratio or P/BookValue.) He is following a similar investment scheme with Amazon, which I will discuss below.

Anyway, the point here is that, it looks like a joke in hindsight but the market actually chopped off 50% of Dell's market cap back in 1996. That is a huge drop and some might say that the market is correctly predicting further problems, I think it is worth looking at those opportunities.

Lehman Brothers During Russian Debt Crisis

The current crisis facing Lehman Brothers must seem like deja vu to employees and shareholders. Lehman shares actually dropped around 70% back in 1998:



The Russian debt default in 1998, along with the collapse of the Asian Tigers before that, caused all sorts of problems for investment banks, particularly someone whose main business was in bonds as Lehman was/is. Similar to the clouds hanging over some financial firms right now, the survival of some were questioned back then.

I'm not saying an Ambac is a Lehman in 98, but anyone fleeing the stock because of the huge collapse in price turned out to be wrong. If you are risk averse or are not a stockpicker then you should avoid these situations but otherwise...

Amazon During .COM Bust

Investing in Amazon throughout the 2000's shows the prototypical Bill Miller; but it is also what makes many disapprove of his strategies. Amazon got killed after the .com bust. It declined 90% from peak to trough, had very high capex in early 2000's, and had no earnings until 2004.



Bill Miller bought early but he averaged down after the stock dropped. Synchro and others are not big fans of averaging down into seeming bankrupt companies (Amazon dropping 90% would have been a candidate if you relied on the market price to gauge reality) but this example goes to show when, how, and why it works!

Bill Miller was likely down significantly on his Amazon investment in 2001, but by 2004 I think he would have more than made a handsome return. Massive price declines are lethal to portfolios but the upside from averaging down on those losing positions is pretty high, assuming they work in the end:

For example, let's say you invested $1000 in Amazon at the peak price of around $100. It dropped 90% in 2001 to, say, $10. No doubt you would be ready to jump off a cliff, assuming there are cliffs in your area--can't find any in Toronto ;) . If you are pretty certain that fundamentals are still solid then if you invest another $1000 @ $10, then there is the possibility of making back your loss and a lot more. When Amazon recovered to $50 by 2004, your return would have been 175% (30%+ annualized). Even though Amazon is actually down 50% from its peak, you are still up quite a bit. Now, this is an extreme example--the drop, as well as the recovery--and I do not think you can expect similar returns in other cases. Nevertheless, I think it makes sense to average down if you invest in distress situations.

Much to the criticism of many, what Bill Miller is attempting to do with his current portfolio is similar. I have no idea if his bets on Countrywide Financial, Yahoo, Pulte Homes, and so forth, will work out. But I don't see how one can criticize the strategy if the reasoning for the business is sound. You shouldn't blindly average down into every single losing position. Some companies will certainly go bankrupt. But if you are certain that the fundamentals or the business itself had not changed, then I think it is a reasonable strategy.


Someone reading this blog might think I'm dumb for saying this but if I had to develop some skill in investing, it would be to pick companies like Amazon. Believe it or not, Amazon is a dream stock to own for me (but it's wildly overvalued right now so I can't buy it.) Before I was seriously into investing, I thought Amazon was going to go bankrupt. I held this view as recently as 2005. But after reading some thoughts from Bill Miller, I have completely changed my view of Amazon (and other growth stocks.) My opinion is that Amazon has absolutely massive moat (I never realized this initially and only changed it after looking at Amazon the way Miller did.) Amazon has 50% ROE (even if unsustainable, it leaves lots of room for erosion), very low debt, strong brand, and global potential. The only problem--and a big one at that--is that it is trading at ridiculously high valuations. Trailing P/E is around 70 and forward P/E is around 40. I think if growth investors get tired of it, or if the bear market chops down the price, it is worth investigating further. The US government is trying to tax online retail sales and if that causes a big sell off, it is worth looking at.

Whenever people read Buffett's words, they seem to think of what he is good at: insurance, branded consumper products, etc. For instance, Buffett likes companies with high return on equity, low debt, recognized brand, strong moat, financially sound, and so on. Newbie investors generally seem to think that what Buffett is saying means we need to find some consumer-branded business like Coca-Cola, Pepsi, Kraft, P&G, or some such business. Yet Amazon satisfies most of what Buffett looks for. Admiteedly, it is hard to value and seems wildly overvalued (at least on a P/E basis) but how come hardly anyone even takes a cursory look at it? The closest to a value investor dabbling in these businesses would be Francis Chou and his investment in overstock.com.


We Are Stockpickers--Or At Least Trying To Be


Synchro: For a stock to drop 90%, it needs rise 10x to break even. What are the odds?


But that's why most investors who pursue that strategy average down. I would agree with you that a 90% drop would be hard to make up. But something like a 50% drop can be made up (just requires 100% gain.) The key thing is that you will only likely make up that gain if the market is irrational pricing the stock. It would be very difficul to make up that gain through busines fundamentals (i.e. it will literally take 10 years to generate profits to create a 100% gain.) (I should note that the revenue argument doesn't apply to financial companies right now since most of their losses are mark-to-market losses, which can reverse without much effort by the business operators.)

Anyway, I think the big difference between your thinking and mine is that, I assume that people who follow these strategies are stock pickers! Or at least trying to be :) When you say "what are the odds?", that's totally meaningless in my eyes. One may not know what the odds are but one may have an idea of the upside if they were picking individual stocks. If you understood the company, it wouldn't be based on trying to guess the odds of recovery, and instead would be based on some fundamental reason. I hope no one is investing based on the blind notion that something may recover because it dropped; someone should be investing due to their expectation of the upside based on fundamentals (the outcome may or may or may not be what one imagined but at least you have some logical reasoning.)


Last Word

I think everything comes down to the strategy followed by the investor. Just like how some people believe in high diversification while others don't, I think investing in stocks that have collapsed may be risky to one but not to another. For me, I think these stocks are no more risky than, say, trying to ride the latest trend (commodities right now, but real estate and technology/growth stocks a while back.) I don't think one can criticize someone like Bill Miller just because they invest in beaten-down stocks.

I'm sure the skeptics will be thinking that the investment cases I cited involve superinvestors. Are we those superinvestors? Who knows, but I'm trying to see if I can develop some skill. I'm sure anyone reading this blog or doing stock picking (as opposed to passive investing or betting on sectors) are trying to see if they will become a successful investor as well. We don't need to make super-high returns and make the front page of the paper; we just need to beat the market by a few percentage points and we'll be fine!

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2 Response to Does It Make Sense To Buy Stocks That Have Fallen Off A Cliff?

contrariandutch
June 23, 2008 at 4:32 PM

Very good. Sums up the essence of why value and contrarian investing strategies work. I would add one point.

The idea behind value and contrarian strategies is that the market sometimes severely misprices securities. Usually this happens because there is a real problem but the scope of the problem is wildly aggagerated. The bigger this mispricing the bigger the potential gain when the market discovers the error and corrects. In other words, if the steep fall in the price of a stock is the consequence of market error instead of fundamental problem, then the upside will be proportionally bigger if the fall has been deeper. To stick with our own favorite contrarian bet, Ambac, it is now trading at maybe 7% of adjusted book value if the marks to market fullly reverse. That means that theoretically the stock could rise a vertigo inducing 1500% before hitting fair value (if marks to market fully reverse which is far from certain).

This means of course that if you can get a good contrarian pick and have the confidence to "load up the truck" you need only a few successes to get excellent longterm returns. One 1500% return on a big position will pay for years of sitting on your hands in search of something good and can allow you to have half a dozen misses. The best part is that if you did your homework right the downside is very limited. Heads you win, tails you get your money back.

Buffet suggests this is his favorite method, sit on piles of cash and load up when the market goes bonkers. He also said that the bulk of his fortune is the product of a dozen investements at most and the best thing for an investor would be to have a punch card with twenty or so slots and you have to punch one everytime you buy something and can't buy anything anymore when you used all twenty slots. That way you are forced to think real carefully before buying.

And this brings me back to the question Synchro put before me about what I believe my edge to be. I noted that I always read a lot about any potential investments before buying anything. Synchro said this was mere "financial archaeology" that serves no purpose as all knowable information will be known and fully discounted by the market (Efficient market theory essentially) but I think you have now saved me the bother of explaining at lengt why reading up on your subject is not just "financiel archaeology" and does serve a usefull purpose. The market does make mistakes, you gave several good examples, and only by carefully studying individual companies and their circumstances is it possible to spot the case where the market is simply wrong. In all the cases you mentioned, the information that led to the eventual sharp recovery was there for all to see, yet few acted on it. Those that did act were amply rewarded. Most market actors rely on superficial information only, skimming headlines, and any investor can gain an edge by digging deeper.

The problem is screening for candidates that merit closer examination as it is impossible to study up close every one of the many thousands of stocks on the market. It is in this screening that I think a contrarian approach is helpfull as you can limit your studies to companies that have recently fallen very hard. Many times the fall will be justified but every once in a while it is not and is an almost inevitable prelude to a dramatic rise.

Deep vale investing is maybe difficult and dangerous but can be very rewarding. I just remembered a story I read in the newspaper about a year ago about a Belgian guy who spend years and thousands of dollars buying up shares of the long defunct Congolese railways. For many years he travelled around Belgium and bought the stock for a few pennies a share whenever he found some for sale. Everybody thought he was utterly if harmlessly insane buying stock in a long bankrupt company. They figures maybe it had some sentimental value to him or perhaps he liked the idea of being a big stock owner, like other crazies think they are Napoleon.

Then last year the bankruptcy receivers finally wound up the Congolese railways (it took them only thirty or forty years or so) and the shareholders equity was about 9 euro/share...

The nutty Belgian at that point held something like a half million shares and was a multimillionaire overnight.

The newspaper presented it as a "fait divers", the story of a crazy guy getting really lucky. Something tells me however that this is actually the story of a guy who did his homework really well and was very patient and saw it all pay off. The ultimate deep value investor.

Dave
September 23, 2011 at 10:39 PM

I have looked Hi and Lo for a description of distressed stocks. Thank you for your excellent explanation. I am adding your blog to my Favorates and will return.

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