When searching for potential investment opportunities, I usually look for companies that have an unwarranted assumption built into their price that does not reflect the long-term earnings power of the company. While there are different ways to find out companies where this is the case, here are three things that I usually look for:
1. Buy When A Maligned Reputation Does Not Match The Operational Results. This might be one of my favorite ways to establish a long-term position in a company. A lot of times, a company will generate negative in the mainstream press, causing the price to become artificially depressed.
McDonald's (NYSE:MCD) and Wal-Mart (NYSE:WMT) are good case studies of this effect. Last year, allegations that Wal-Mart's Mexican subsidiary hid its bribing activities of government officials from the headquarters office in Bentonville caused the stock to fall 5%. Since April 24th, 2012, Wal-Mart has appreciated by 35%. For the purposes of comparison, the S&P 500 is up 22% in that time frame. Since at least 1997, Wal-Mart has never had a year where sales per share, cash flow per share, earnings per share, and dividends per share failed to increase. Despite the fact that many news outlets treat Wal-Mart as the synecdoche representation of all that is wrong with corporate America, the negative news about the company does not translate into balance sheet damage.
McDonald's is the classic case of a company that is always being hounded (to varying degrees) in the mainstream press. That was particularly the case in 2002 and 2003.The "national conversation" about healthier food options (which manifests itself in odd ways such as the elimination of the Super Size Fry, local ordinances restricting McDonald's from adding a ball pit, calls for the elimination of Happy Meal toys, etc.) caused McDonald's stock to fall from $30.70 to $15.20 in 2002 and from $27.00 to $12.10 in 2003.
The interesting thing is that, operationally speaking, McDonald's actually improved its business performance as its stock price dragged. The company was growing earnings from $1.32 to $1.43 per share, increasing the annual dividend from $0.235 to $0.40 per share (and by the way, McDonald's really did pay its dividend annually then before switching to a quarterly payout in 2008), and buying back stock throughout the process. A $10,000 McDonald's investment in June 2003 would be worth $62,280 today and would be paying out $1,880 in total dividends. Ignoring the headlines to focus on business performance can be a lucrative endeavor.
2. Buy When The Company Has A Short Term Problem. From the price of $62 per share to $75 per share, I was a net buyer of Johnson & Johnson (NYSE:JNJ) stock. Throughout most of this period, the company was being dogged by product recalls. While this was happening, I was reaching two conclusions about Johnson & Johnson:
(1) This company is diversified enough to withstand abuse in some areas and still reward shareholders. The cash flow per share kept going up. It was $5.69 in 2009. It was $5.92 in 2010. It was $6.25 in 2011. It was $6.48 in 2012. The dividend grew each of those years. The newspaper headlines in Barron's and The Wall Street Journal kept lamenting the difficulties at Johnson & Johnson and the problems with management, but a read of the balance sheet revealed a company gushing out more and more profit.
(2) Even if the company did endure apparent damage to the balance sheet as the result of the product calls and other management blunders, they were likely to be short-term in nature. If I were a betting man, I wouldn't guess that Johnson & Johnson investors in 2019 would vividly recall the 2010-2012 period as "the beginning of the end" for the company. Instead, I reached this conclusion: if the company is delivering satisfactory results while having atypical operational problems, imagine the bump in profits that will result when the company eventually gets its act together.
3. Buy when a dividend cut is due to "political risk" instead of operational deficiencies. Besides the fact that an income investor (including myself) does not like to receive cuts in their cash flow, one of the reasons why dividend cuts are not popular is because they often reflect deterioration in a company's earnings power. After all, if you expect to earn more profits over the next three to five years, why would you cut the dividend?
But when a dividend cut is driven by political pressure, the price of the stock may fall by an amount greater than what the earnings power of the firm may indicate. The United States government pressured BP (NYSE:BP) to eliminate its dividend payout in the second quarter of 2010, even though the company had $18.5 billion in cash on hand and even declared the dividend before retracting it due to political influence. The price of the company fell below $27 per share.
Another example of this is Wells Fargo (NYSE:WFC). In 2009, things looked pretty bleak when the dividend got cut from $0.34 per share quarterly to $0.05 per share, and the stock price fell below $8. But that dividend cut was artificial and not driven by earnings reality. As Warren Buffett explained in the 2010 Letter to Shareholders:
In addition, dividends on our current common stock holdings will almost certainly increase. The largest gain is likely to come at Wells Fargo. The Federal Reserve, our friend in respect to Goldman Sachs, has frozen dividend levels at major banks, whether strong or weak, during the last two years. Wells Fargo, though consistently prospering throughout the worst of the recession and currently enjoying enormous financial strength and earning power, has therefore been forced to maintain an artificially low payout. (We don't fault the Fed: For various reasons, an across-the-board freeze made sense during the crisis and its immediate aftermath).
At some point, probably soon, the Fed's restrictions will cease. Wells Fargo can then reinstate the rational dividend policy that its owners deserve. At that time, we would expect our annual dividends from just this one security to increase by several hundreds of millions of dollars annually.
Since then, the price of the stock has rebounded to above $40 per share and the company is paying out $1.20 per share in annual dividends. Given that the company plans to accelerate its payout ratio even more over the next couple of years, it is likely that the results of Wells Fargo purchases during The Great Recession will continue to magnify even more with the passage of time.
All three of these stock picking strategies share one common element: they look for superficial blemishes that underscore long-term earnings power. When a company like McDonald's or Wal-Mart has a bad reputation, check to see if it affects cash flow, earnings, and dividends. When a company like Johnson & Johnson is having operational difficulties, determine the scope of their effect on the company's current bottom and then determine whether it is a short-term or long-term problem. And lastly, when a company cuts its dividend (especially due to political pressure), it can be worthwhile to examine whether the subsequent price decline overshoots your assessment of the company's long-term earnings power. These strategies may not suit the needs of every investor, but they do provide fertile ground for investors searching for value.