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Contrarianism and Negativity

April 16, 2006 | About:

by Geoff Gannon

Undervalued stocks usually suffer either from contempt or neglect. In some sense, I suppose it's true that there are beloved bargains out there; they just aren't beloved enough. But, I don't think you're going to find too many of those. Even though a stock may be a bargain when it trades at a higher than market multiple, I haven't seen many bargain stocks that were actually better liked than both their peers and stocks in general.

I spend most of my time looking at stocks that suffer from neglect rather than contempt. That's one of the great virtues of small cap stocks. There are so many small cap stocks that a few are always suffering from neglect. Most investors only have time for the hottest names in small caps. Otherwise, they would have to look at thousands and thousands of individual businesses.

That's why I'm always interested in companies like Village Supermarket (VLGEA). Today, Village has to perform to justify its P/E of 12. But, a few years ago, Village didn't have to accomplish much of anything to justify its P/E of 6. You could have bought the stock at a P/E of 6 and a 50% discount to book value around the time of the millennium bubble.

Those were good times. It seemed every earnings report surprised investors, because no one was paying attention. Oh? Earnings are up again? Well, I don't really like the grocery business; but, at a P/E of 5, I guess I have to buy.

While some institutions can't put meaningful amounts of money to work in a select group of small cap stocks, there are enough reasonably sized small caps that individuals don't have to worry about having more money than ideas. Of course, this may not be true at any given moment. But, generally, there are plenty of opportunities among stocks that suffer from neglect.

So, why should investors even consider buying stocks that suffer from contempt? Isn't buying such stocks a lot riskier than sticking to those stocks few people care about?

I'm not sure it's a riskier strategy to pursue. But, it is more psychologically demanding. You have to be willing to wake up each morning and have The Wall Street Journal and CNBC disagree with you - and that's on the good days. On the bad days, it will be USA Today and the evening news.

If you can remain rational when others can't, you should do well with your contrarian positions. But, you mustn't take them for the sake of being contrary. You shouldn't find pleasure in disagreeing with the consensus; you should find pleasure in being right regardless of what others think. Of course, because what others think is largely what sets the price of stocks, you'll likely find some of your best bargains on the other side of a trade from someone consumed by negativity.

Where has the negativity been lately? Some well-known value investors have been taking a good look at media stocks lately. Media isn't one of my favorite places to look for bargains, because there are plenty of people who know a lot more about the business than I do. But, there have been some interesting looking opportunities lately.

I'm pessimistic on the long-term prospects for daily newspapers and terrestrial radio. I like JRN and JRC, because things don't look as bad at these businesses as they do at some other, better known media companies. Journal Communications isn't just a newspaper company; and Journal Register isn't a big city daily newspaper company. That may not sound like a lot. But, it's something - and I didn't think it was priced into the shares. In both cases, there's a lot of cash flow. Journal Communications also has the benefit of a strong balance sheet.

Now that I think about it, I realize most of the stocks I was interested in during the first quarter of 2006 were suffering from some sort of negativity.

People are negative on Lexmark (LXK) both because they're negative on the printer business and because they like Dell and HP more.

Any time you find a stock that people buy or sell because of a bigger story, you'll have pretty good odds betting against the crowd. This isn't because the bigger stories are wrong. It's because they're too big. They don't apply equally to all the stocks they touch.

For instance, Wal-Mart did crush a lot of other retailers. But, it didn't crush all of them. An astute investor would have asked what the chance was that Wal-Mart would destroy a particular business. In some cases, where there was a lot of bloat, you would have shied away from the stock. But, in other cases, where there was already a business doing things quite cheaply, you would have been willing to buy the stock when it dropped to very low price-to-earnings and price-to-book ratios (as Village did in the late 90s).

Pacific Sunwear (PSUN) suffers from a special kind of contempt. It has committed the unforgivable sin of growing old. PacSun is no longer the growth stock it once was.

Wall Street has a tendency to go to extremes. I'm sure you've noticed this. What you might not have noticed is how that tendency can cloud one's judgment in particular cases. Pacific Sunwear won't grow like it once did, but it will grow. Nothing's certain, but that's the best bet. At current prices, the odds on that bet are out of whack. PSUN is priced as if its future growth will be very close to worthless. That's why it's now a value stock.

Sherwin-Williams (SHW) was slapped with an adverse ruling in Rhode Island. The lead paint liability sent the shares down; they're up quite a bit since then. This is an example of a good company that got hit by a lot of negativity. The price drop wasn't big enough to make the stock an obvious bargain. But, for those who took the time to study Sherwin-Williams, it offered an opportunity to buy an above-average company at the kind of price an average company would normally sell for.

The Street's contempt for Overstock.com (OSTK) has been hard to miss. Three out of every two people I've talked to are short this stock. That alone isn't a good enough reason to buy a stock. The real reason to buy Overstock is pretty simple: it's cheap. I've made that case before, so I won't bore you with it again.

Those were some of the stocks I liked last quarter. Sure, I still like them at today's prices; but now it's time to think about what new bargains Mr. Market might offer in the second quarter?

Negativity is often most interesting when it is focused on an industry cycle, macroecnomic trend, or health scare. Homebuilders, steelmakers, and chicken producers are all good stocks to keep an eye on. At some point, you might find a few stocks that are so cheap you don't need to worry about where in the cycle you are.

Look for low debt levels, a history of free cash flow generation, and above average profitability. To value these companies, come up with a conservatives estimate for normalized earnings. More importantly, if you can get a better than average player in the industry at close to book value, you might want to consider it. Start your search with companies that are either small or foreign.

You could take a completely different approach to exploiting negativity. Instead of looking for conspicuously cheap stocks, you could look for great businesses selling at bargain prices. H&R Block (HRB) is a great business with a lot of negativity around it. There are serious questions here about the long-term prospects for the business and the kind of returns that will be earned on incremental capital. But, it's certainly an interesting stock.

Harley-Davidson (HDI) and Intel (INTC) are two other stocks worth watching. Again, there are a lot of long-term concerns. Recently, Harley has grown the business, but there are a lot of reasons to think that isn't sustainable. Intel hasn't grown much at all in years, but is still talked about like there will be growth ahead.

Some of the negativity around Intel has to do with competition. All of the negativity around Harley has to do with demographics. Those facts would tend to favor Harley, because both the brand and the industry will last regardless of the demographics. Intel has no brand to speak of, and I have no idea what its industry will look like in a few decades.

Finally, whether you have a contrarian streak or not, don't underestimate cash flow or cash on the balance sheet. One of the best indicators of a bargain is a low enterprise value-to-EBIT ratio.

Whenever you hear bad news about a big company, run the EV/EBIT ratios for smaller players in the same industry as well as the big company's customers and suppliers. If there's continued bad news about more than one company in the same industry, it's a pretty good bet one of their rivals, customers, or suppliers has been beaten down to bargain levels.

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Geoff Gannon writes a daily value investing blog and produces a twice weekly (half hour) value investing podcast at Gannon on Investing.


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