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Vitaliy Katsenelson
Vitaliy Katsenelson
Articles (126)  | Author's Website |

The Blessing of a Declining Stock Price (Call me a Charlatan)

December 01, 2013 | About:

After I told my father what I am about to tell you, he called me a charlatan. He said, “You basically tell people that it is okay to lose money on their stocks.” It’s a bit more nuanced than that, but, yes, here is my message to you: When you buy the right company — one that generates enormous cash flow and is run by good capital allocators — a decline in the stock price could be a blessing, not a curse.

Okay, now it’s your turn to call me a charlatan. But before you do, let me share with you two examples: one that has already played out and one that is still very actionable.

In May 2012 I made the case for Redwood City, California, gamemaker Electronic Arts. My firm’s original premise in buying EA was that it looked expensive statistically, but statistics did not capture the company’s true earnings power. EA is transitioning from selling packaged games to digital ones. Digital games come with much higher profit margins; thus, even with little revenue growth, EA’s margins should go up. And they have. In fact EA’s fundamental story worked as we expected.

During the third quarter of 2013, we sold Electronic Arts in two tranches, the first time in the mid-20s, the second time in the high 20s.

However, right after we bought the stock, it declined nonstop for more than six months. Here is where the lesson comes in: A stock decline is not necessarily a bad thing, even if it happens right after you buy (assuming fundamentals have not collapsed). When we buy stocks, we believe they are irrationally priced — that is, selling at a discount to their fair value. But just because we bought a stock doesn’t mean it will not become even more irrationally priced. At the time we buy a stock we believe it is undervalued — otherwise we would not have bought it — but we have no idea whether it will go lower.

There was a lot of good that came out of EA’s stock decline. First off, we had an opportunity to buy more. Second, EA bought a lot of its own stock. This share repurchase created value for shareholders and allowed us to reset our second sell target to the high 20s. (We were initially willing to part with all shares in the mid-20s.)

The same thing is happening with the stock of another company that I’ve discussed in the past: Xerox Corp. The case for Xerox that I laid out to you was straightforward: Investors put this company in the same has-been wastebasket as Eastman Kodak Co.: obsolete technology, leveraged balance sheet, two steps away from the grave. This perception creates an opportunity, because Xerox (NYSE:XRX) is not Kodak.

Roughly half of Xerox’s revenues comes from services. About 30 percent of revenues comes from copier supplies — which are very recurring and not going anywhere — and only 20 percent comes from selling copiers. Old habits formed over decades die hard; so business printing, though it isn’t growing, is at worst a very slowly declining annuity (and color printing is actually growing). In the meantime, Xerox’s nonprinting business is growing quite well and has been offsetting the decline in printing. The company’s net debt, at $6.5 billion, appears to be high, but it isn’t; two thirds of it is financed debt used by Xerox to pay for its copiers. Xerox’s corporate debt is less than $2 billion.

Despite the false appearances, Xerox is a solid company. Its free cash flow exceeds earnings by a third (we put them at about $1.50 a share).

After we bought Xerox, it declined for about a year. We bought more shares. The company has taken advantage of its stock price decline and bought back 7 percent of its shares over the past six quarters. At the same time it has reduced its debt by almost $2 billion. On last quarter’s earnings call, Xerox’s management discussed increasing share buybacks.

When a stock trades at a bit more than six times (stable) free cash flow, you can create an enormous amount of value through buybacks. In fact, as paradoxical as it may sound, we don’t want Xerox stock to go up much; we want the company to buy as many shares as it can, and cheaper prices help that. Xerox’s stock will be doing nothing, stagnating or, hopefully, declining, until one day investors wake up and realize that the company’s free cash flow per share has exploded, and then so will its stock price.

It may be painful to see your newly minted position show losses right away or remain below your purchase price for a long time. But if a company is taking advantage of its stock’s cheap valuation through share repurchases, the intrinsic value of what you own is actually enhanced by the price decline. In fact, a stock price decline might be the best thing that happened to you since you bought the company, especially if your time horizon is longer than a few quarters. Call me a charlatan, but that’s investing for you.

About the author:

Vitaliy Katsenelson

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of The Little Book of Sideways Markets (Wiley, December 2010). To receive Vitaliy’s future articles by email or read his articles click here.
Investment Management Associates Inc. is a value investing firm based in Denver, Colorado. Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process, as detailed in Vitaliy’s book Active Value Investing (Wiley, 2007).

Visit Vitaliy Katsenelson's Website

Rating: 4.2/5 (19 votes)


Superguru1 - 3 years ago    Report SPAM
Since beginning of year, XRX price has gone up some 56%. What are you estimating XRX intrinsic value?
Handworn - 3 years ago    Report SPAM
"To refer to a personal taste of mine, I'm going to buy hamburgers the rest of my life. When hamburgers go down in price, we sing the 'Hallelujah Chorus' in the Buffett household. When hamburgers go up in price, we weep. For most people, it's the same with everything in life they will be buying -- except stocks. When stocks go down and you can get more for your money, people don't like them anymore." -- Warren Buffett, 2001
Superguru1 - 3 years ago    Report SPAM
As a value investor, it is so hard to buy stocks at 52 wks high. Even though they might still be cheap. I need to get over this my psychological barrier.
Tannor - 3 years ago    Report SPAM
Excellent Article and examples.

Based on past experience under 7x FCF is always worth a second look, pinpointing why is the important factor.

"Long ago Ben Graham taught me that Price is what you pay; value is what you get. Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down." - Warren Buffett

Taowave - 3 years ago    Report SPAM
Its only a blessing if you average down and have and have the proper money management and position sizing to do so....

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