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Digging in the Scrap Heap

Henry W. Schacht

Henry W. Schacht

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The most recent edition of Grant's Interest Rate Observer has an article entitled "Buy beer, sell bonds". For a moment, I thought it was a call to serious alcohol consumption funded with loads of borrowed money! No such luck. Instead Grant's is bullish on beer stocks (specifically Molson Coors) and bearish on bonds (especially Treasuries). For those who agree, consider buying TAP and TBT (the Ultra-Short Treasury ETF).

The following paragraph from the article is worth repeating here:

Mr. Market delights in switching labels. When he sticks the "risky" label on the "safe" asset, and the "safe" label on the "risky" asset. Yet, not infrequently, it's the supposedly risky asset that winds up preserving capital or even delivering capital gains. It all depends on price. At a price, junk bonds are gilt-edged and Treasurys are junk. At 20 cents on the dollar, subprime mortgages can me - truly, if unofficially, - triple A. More often than not, investment safety is what you find on the scrap heap.
Just days after reading this, a friend directed me to an interview of Bruce Greenwald (Columbia professor & value investor). The interview was done by Steve Forbes as part of his Intelligent Investing with Steve Forbes series. In it, the professor echoes the Grant sentiments above.

In a far-ranging interview, the topics include the nature of the true value investor, competition, valuation methods, media, anti-trust, and even Animal House.

Greenwald offered a handful of (provocative, yet familiar) opinions on individual stocks. He believes Amazon.com (AMZN) and Apple (AAPL) are severely overvalued, quickly admitting that he's been very wrong so far. He sees sporadic values in media, like Comcast (CMCSK), and telecom services (France Telecom & Turkey Telecom... maybe AT&T and VZ too). IXP, anyone?

More broadly, Greenwald discusses structural reasons why Japan and Europe have lagged economically. (This doesn't extend to every company based in these regions however... more later) By extension, he suggests investors should be wary of China and Brazil, two economies beloved by many today.

Favorite quotes from the interview:

On value investing in general -

...first, you want to stay away from the lottery ticket stocks. People in every country have always paid for lottery tickets. They've always been crappy investments and they're paying for the hope and the dream. So you want to stay away from that. Second thing is in life, as in investing, people are overly averse to what's ugly, disappointing, cheap and you really want to go there.
On Amazon:
What (Amazon is) selling is this idea that they're going to continue to grow and they're going to have negative working capital. Negative working capital's an invitation to competition, right? So why they think that ultimately is not going to be competed away is beyond me. So that, I think, is a bubble.

We've discussed in these pages the ongoing love affair investors have with all things tech (especially anything "virtual") and Amazon in particular. No question, being a value investor can be painful in the short-run. But chasing good news isn't a recipe for success either. What is that Buffett line about paying dearly for a rosy outlook?

So in a world where the labels (safe & risky) are often switched, I continue to search through the scrap heap for that which is ugly, disappointing, (and) cheap. Not surprisingly, this investor has been finding value in Europe (and oil & oil services), among other places.

In the case of BP plc (BP), it wears both unpopular labels. And then there's that small "issue" in the Gulf of Mexico (sarcasm very much intended). Despite the bad news (or because of it), I think BP is a compelling value. Those speculating about a possibility of bankruptcy obviously have no appreciation for the size and scale of BP. Just as those who believe we (as a country) can "get off of" fossil fuels in a few years have no comprehension of the scope of our energy needs. Ever compare the energy output of a solar panel with a barrel of oil? I've got nothing against windmills, but let's be serious.

BP's reported earnings over the last 5 years approaches $100 Billion on sales of nearly $1.5 Trillion. The oil spill (and troubles with Europe and the euro) won't change the earning profile of the company. The costs of the spill ($20 billion?) have to be weighed against these profits and the massive drop in market value. At the current price, this investor believes the bad news is priced in... and then some.

Elsewhere in Europe, globally diversified companies are being lumped in with the corner grocery store and the local housing contractor. You won't find me bidding for a Spanish homebuilder. That said, Telefonica (TEF) is a steal, even if they persist in their bid for control of Brazil's Vivo (VIV). Europeans or not, most people (especially young ones) view their cellphones like the late, great Charlton Heston did about his guns... "from my cold, dead hands"!

Telefonica's free cash flow makes my capitalist heart leap for joy. The 7+ percent dividend doesn't hurt either. Given TEF's business and global exposure, both are probably safe. This is an excellent global company. It just happens to be based in Spain.

In the same vein, Banco Santander (STD) is another recent purchase. More risky? Yes, but I think the price is right for a global company being tarred with the big euro brush.

Continuing on our European vacation, take a look at Vivendi (VIVDY). It's another member of the Big Dividend Club. The company has major stakes in NBC Universal, Activision (ATVI), Canal+, and other telecom/cable/media assets from Turkey to Brazil. Even accounting for a sizable debt load, a $30 intrinsic value isn't hard to reach. Pretty compelling considering a $21+ current quote.

The scrap heap is full of large diversified companies based in Europe. Take a look for yourself. The pundits would have you believe they are exceedingly risky. But that was true when everyone loved them. Not now.

Macro economic concerns need to be placed in their proper context. Japan's fiscal situation is pretty ugly with debt and deficits galore. But the Japanese corporate sector is in decent shape. Many are dramatically underleveraged in stark contrast to the government. One example: Nintendo (NTDOY). It was an amazing investment (personally and professionally). The company is solidly profitable and sports a balance sheet with at least $10+ billion in NET cash. A falling yen helps Nintendo. The same is true for multinationals based in the euro-zone.

Disclosure: Long BP, STD, TAP, TEF, and VIVDY.


Henry W. Schacht

http://www.lonelyvalue.com/

About the author:

Henry W. Schacht
Henry W. Schacht, CFA is the founder of Schacht Value Investors, an investment management firm serving individuals and institutions. He currently serves as President and Chief Investment Officer. He earned his MBA at the University Of Chicago Graduate School of Business and a BBA in finance from the University of Notre Dame. Mr. Schacht is a member of the Association for Investment Management & Research (AIMR), the Investment Analysts Society of Chicago (IASC), and the National Association of Corporate Directors (NACD).

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