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Cheap Stocks Keep Getting Cheaper: Fundamentals and Warning Signs

October 19, 2012 | About:

Holly LaFon

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Last year, several large, well-known companies became cheap enough to attract numerous big value investors. The big question surrounding many of these companies was whether they would overcome their problems, or were in permanent decline. Now several of the companies that seemed cheap then have gotten even cheaper.

Hewlett-Packard (HPQ)

Hewlett-Packard’s stock traded for more than $40 for most of 2010. Then, its stock collapsed in the second half of 2010, losing about 50% for the full year. It declined still further in 2012, touching its almost 10-year low of $14.02 on Oct. 10.

Gurus

Six Gurus initiated positions in HPQ following its mid-2010 price drop (including Wallace Weitz, Seth Klarman and John Hussman, among others). Another fifteen added to their positions (including Ray Dalio, George Soros and Donald Yacktman, among others). Gurus have also been buying and adding more in the first half of 2012.

Business

HPQ was, until recently, the world’s leading producer of personal computers, a technology many already view as waning, for six years. It was dethroned in October by China’s Lenovo Group Ltd. (LNVGY), according to research Gartner Inc. released on Oct. 10. Lenovo’s market share increased to 15.7 percent, while HP’s share of the market was at 15.5 percent.

PC shipments worldwide declined 8.3 percent in the third quarter of 2012 from the previous year, according to Gartner. Four of the five top vendors in the U.S. market saw their shipments decline.

“HP is currently restructuring its device business, including PCs, tablets and printers. HP's main concern is achieving a good balance between market share gain and margin protection,” the research company said.

The past 12 months

From a valuation standpoint, the company has become significantly cheaper than it was the same time last year:

HPQ ps,pb Interactive Chart



Steve Romick, portfolio manager of the FPA Crescent Fund, said in a recent GuruFocus interview that his purchase of HP at the price he paid was a mistake:

Romick: You know how I said earlier good things happen to cheap stocks? Sometimes not such good things happen to cheap stocks. Hewlett Packard was a mistake. Pure and simple it was a mistake. We bought a stock we probably should not have bought, and we certainly paid too much for it. HPQ is certainly the worst stock I’ve had at least on a market-to-market basis in terms of total dollars lost. It's not ideal, and we’ll learn a lot more next month. The first week of October, there’s an investor day, and our hope is that they’re able to successfully articulate a clear strategy, which is something that they’ve failed to do thus far. It’s under new management at this point in time, and they’ve got the benefit of the doubt. But this is not going to be any kind of quick turn. Fortunately, the only saving grace I can tell you is it was never a big position. It was a smaller position, thank God.


Warning Signs

Several warning signs about the company’s fundamentals raise caution, according to GuruFocus. One Severe Warning sign is its Altman Z-Score, which is a forecaster of bankruptcy up to two years prior to distress with 80% accuracy. A Z-Score less than 1.81 is in distress zone, in between 1.81 and 2.99 is in grey zone, and greater than 2.99 is a safe zone. HP has an Altman Z-Score of 1.51, indicating distress.

The second severe warning sign is its Piotroski F-Score, which measures business profitability by metrics such as return on assets, cash flow and quality of earnings, among others. A Piotroski F-Score of 8 or 9 is good or high; a score of 0 or 1 is bad or low. HP has a Piotroski F-Score of 2.

Third, it has a severe warning sign for its long-term debt. The company keeps issuing new debt and has issues $13.4 billion total over the last three years.

HP has three medium warning signs as well, for: a slowdown in per share revenue growth over the past 12 months, a poor buyback track record and a operating income loss over the past three years.

RadioShack (RSH)

Another controversial value play is RadioShack, the electronic goods and services retail chain. Its shares have fallen to close to a 10-year low, and have been on a fairly downward trajectory beginning in late 2010, from $22 per share in October of that year to an opening price at $2.39 on Friday.

Gurus

Since the fourth quarter of 2011, seven Gurus have bought or added to their positions of RadioShack and five have reduced or sold out.

Business

RadioShack’s business fundamentals have recently taken a downturn as it faces greater competition from Walmart and Amazon and a weak economy. It had revenue growth from 2008 to 2010, but it declined from $4.5 billion that year to $4.4 billion in 2011. Its revenue has also declined for the past three quarters. Earnings also fell from $206 million in 2010 to $67.1 million in 2010. Losses in the first quarter of 2012 deepened in the second quarter.

RadioShack has generated positive free cash flow for the past ten years, and two quarters of negative free cash flow in the past year. Its return on equity and return on assets declined from 2010 to 2011, as did its gross margin, operating margin and net margin.

Past 12 Months

The company has become significantly cheaper from the same time three years ago, based on its P/B ratio and P/S ratio, which is at its three-year low:

RSH ps,pb Interactive Chart



Warning Signs

GuruFocus gives RadioShack two severe warnings signs. The first is for its gross margin being in long-term decline at an average rate per year of 2.2%.

The second severe warning sign is for its operating margin being in five-year decline at an average rate of 2.8% per year.

Research In Motion (RIMM)

Research In Motion’s shares have declined more than 65% in the last year, from $22.31 a year ago to open at $7.88 on Friday.

Gurus

When the stock price began to decline significantly in the second half of 2011, ten Gurus initiated a position or added to their positions; two closed out or reduced theirs. Prem Watsa, notably, acquired more than 10% of the company from the third quarter of 2010 to the first quarter of 2012.

Business

Research In Motion is a mobile communications company and maker of the BlackBerry smart phone, which once dominated the mobile smart phone market. Increasing competition from competitors such as Apple and Google has reduced its market share and earnings, while lack of enthusiasm for new products has stalled new growth.

RIMM’s revenue declined sequentially for three straight quarters, as did net income and losses, but its second fiscal quarter was better than expected. Results showed cash flow increased by approximate $100 billion to $2.3 billion the previous quarter, revenue increased 2% from the previous quarter, and a net loss of $235 million, or $0.45 per diluted share, was lower than analysts’ estimates of $0.47 per diluted share. The BlackBerry subscriber base increased to approximately 80 million globally.

Past 12 Months

RIMM’s P/S and P/B ratios both declined to lower than their levels a year ago:

RIMM ps,pb Interactive Chart



Warning Signs

Research In Motion has four severe warning signs. First, its Piotroski F-Score is 3, which is low. Second, its gross margin has been in long-term decline at an average rate of 7.2% per year. Third, its operating margin has been in five-year decline at an average rate of 17.4% per year. Fourth, its inventory is building up. When this happen, it may mean a company is finding it difficult to sell its products.

Its one medium warning sign is for declining revenue per share over the past 12 months. RIMM’s revenue per share declined from $38.02 in 2011 to $35.17 in 2012.

See GuruFocus’ new warning signs feature here. Checking warning signs regularly can help you avoid making investing mistakes.



Rating: 4.0/5 (21 votes)

Comments

superguru
Superguru - 1 year ago
Companies in Industries which face major technology or business model disruptions can be value traps. Examples other than HPQ, RIMM and NOK are for profit education and GME

Over a year back when I looked at for profit education companies, they were looking cheap because of regulatory concerns. I looked deeper and realized that whole industry is undergoing a major technological disruption. It will probably take 3-5 years to play out. There was no way for me to know which of these current companies will be able to be in forefront of disruption and which will die like Blockbuster. So I stayed away.
marcolanaro
Marcolanaro - 1 year ago
These examples show how difficult is to forecast not only earnings but the future of these companies. If you take RIMM , for example, it does not take much to understand that it could survive and prosper only if few things go right or at least , at this price level, not plainly wrong. By the way, go back 4 years and even though the Iphone was already selling who could have imagined such a bleak future for RIMM or Nokia? Not me, but I never like to buy these companies when they are successful, history teaches us that the visibility is to short and probably distorted.

I also have great admiration for Prem Watsa and his thinking, so I am pretty sure that he is really thinking more about the downside for RIMM than its potential opportunity.

feeling ignorant about RIMM or to scary about forecasting its real prospects but with a contrarian view and an idea that is too cheap to ignore, I loaded up on out-of-the-money call option and very long , 2014. I believe that if something should be happening with RIMM , should happen very soon otherwise it will be to late, there is no plan B for this company.
LivieOliver
LivieOliver premium member - 1 year ago


I think Alcatel-Lucent is a similar story - although Im going to claim that its is much cheaper at a market capitalisation of around 10% of last years revenues. Thoughts?

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