Pretty much every trading day, I take a quick look at the top percentage decliners on the NYSE and Nasdaq. These are the market's train wrecks -- the stocks that have fallen the most from the prior day's close, on a percentage basis. This act is kind of like watching reality television about people who made poor choices in life, in that it makes me feel better about myself. I may be an idiot, but at least I don't own one of those stocks.
More important, I want to see if there are any potential bargains among the lot. People tend to extrapolate present conditions far into the future, so overreactions to bad news (and good news) are both inevitable and commonplace. These deep sell-offs sometimes present an opportunity I like to call "Buy the Plunge."
Why buy the dip when you can buy the plunge?
I'm not talking about mere 10% or 15% declines here, though those can provide compelling entry points at times. An example that comes immediately to mind is Markel's (NYSE:MKL) acquisition of Alterra in late 2012. On December 18, Markel closed at $486.05, and on the 19th, the day of the deal announcement, the stock closed at $436.24, near its lows of the day. That was only a touch over a 10% decline, but it was a relatively large move for a stock that's in strong hands (thanks to a carefully cultivated shareholder base) and exhibits very low volatility. Even the most rational investors lose their cool now and again. Markel recovered the lost ground by early February 2013 and the stock has ripped higher since then on the back of characteristically strong results.
A 10% drop is not a plunge. I'm talking about quotational losses of one-quarter to two-thirds of the stock price -- in a single trading session. (NB: always check that a big decline doesn't simply reflect a stock split). There are all sorts of reasons why a stock might collapse in such spectacular fashion, and the market's harsh response may be perfectly appropriate. Here are just a few:
- Failed drug trial.
- Failed high impact exploration well.
I typically want nothing to do with these situations. What I'm looking for are short-term bumps in the road faced by durable businesses. This may come in the form of a quarterly earnings release or guidance revision that misses expectations by a mile. Maybe it owes to a lost contract with a major customer, or a FX hedging blunder, or an accounting restatement that has no impact on reported cash flows. In a nutshell, I'm looking for solvable problems that do not impair a strong core franchise. That's not to say these situations aren't hairy, or scary. But without the fear and uncertainty, there would be no opportunity.
These massive and rapid dislocations in price feed on themselves, creating panicked, mindless selling. "Just get me out of this dog!" says the fellow firing off his market sell order. Sell-side analyst downgrades of the most useless kind reliably follow, adding further selling pressure. So do momentum-based traders and quant funds.
But How To Take Advantage?
I absolutely do not recommend automatically buying every 25%+ daily decliner that flashes across one's screen. Given the number of landmines, that is unlikely to produce satisfactory results. As Joel Greenblatt says in the bible of special situations investing, you have to pick your spots.
So what is required to profit from these situations? I would say two personal characteristics are essential: sound judgment and the ability to act quickly and decisively. Those characteristics are not commonly found in tandem, particularly among younger investors. Speaking personally, I like to think that I have sound judgment most of the time (especially compared to the kids on 16 and Pregnant), but acting quickly and decisively is something I struggle with. If you have no trouble with the latter, but lack the former, then you're in a worse spot than I am.
If sound judgment and expertise largely boil down to pattern recognition, as the value quants at Euclidean Technologies argue, then there is no substitute for experience (unless you're able to harness machine learning to generate an elegant algorithm). The more experience you have, the easier it is to determine whether a new situation presents a compelling opportunity and develop high conviction. The higher the conviction you have, the easier it is to move quickly while the window of opportunity is open.
Knowledge compounds, making investing an older person's game. See Buffett, Icahn, Stiritz, et al. If you're under the age of 75, and not yet a powerful wizard like those guys, the best thing you can do is study past examples and learn the patterns. In that spirit, I'll present a pair of plunges that I passed on -- but learned from -- as an analyst in 2012, followed by two recent situations that I've seized upon in my personal account.
Past Plunge #1: MSCI (NYSE:MSCI)
MSCI has a terrific franchise in the creation, maintenance, and licensing of indices that are tracked by myriad ETF products, chief among them the iShares MSCI EAFE ETF and the iShares MSCI Emerging Markets ETF, both BlackRock (NYSE:BLK) products with tens of billions in assets under management. MSCI gets a small cut of this AUM, providing massive leverage to the growth in ETFs. In October 2012, Vanguard Group announced that it was dropping MSCI as the index provider on 22 of its funds in an effort to lower fees. Despite Vanguard being a <8% customer -- BlackRock was the largest at 8.1% of 2011 revenue -- MSCI shares fell from $35.82 to $26.21, or nearly 27% on the day. It was a classic overreaction, out of all proportion to the economic impact of the customer loss. The misplaced fear was that other ETF providers would follow suit, but it didn't happen. BlackRock simply countered with a new line of lower-cost Core ETFs, sticking with MSCI as the index provider. With countless asset managers benchmarked to MSCI indices, this is a deeply entrenched business.
MSCI shares regained the lost ground in less than a year. Gallingly, I'd watched this fat pitch sail right over the middle of the plate. Part of my decision to not swing owed to some high-minded concerns about management's capital allocation priorities and misaligned incentives. While noble, those were costly and over-weighted concerns.
Past Plunge #2: Western Union (NYSE:WU)
A few weeks after the MSCI plunge, in late October 2012, retail money transfer leader Western Union came out with a horrendous earnings report that tanked the stock by 29%. The company unveiled a plan to cut prices in order to revive sagging volume, which was really not well received. Investors questioned the company's staying power in the face of potential disruption from PayPal and other mobile upstarts.
I gave this one some thought, could not get comfortable that Western Union was not a value trap, and passed on the idea. WU was back at its pre-plunge level in nine months. I'm still not sure about the long-term durability of this company's moat, but Western Union clearly has more staying power than the crowd was giving it credit for back in 2012. This situation reminds me of a great Bill Gates quote: "We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten."
Present-Day Plunge #1: PowerSecure (NYSE:POWR)
On May 8, 2014, energy technology and services firm PowerSecure fell a staggering 62% following its first quarter earnings release. The company achieved very poor utilization in its Utility Infrastructure division that, combined with a protracted sales cycle in the Distributed Generation division, was going to torpedo earnings for the year. There was a lot of cussing on the conference call. I clock the founder/CEO, Sidney Hinton, at 8 "damns" and 11 "hells". He was clearly fired up. I like to see that. Hinton beneficially owned 2.7% of the company as of the April 2014 proxy, so this decline hit his pocket pretty hard.
Both of Q1's problem divisions have lumpy revenue profiles. On the DG side, which is by far the best and most valuable piece of PowerSecure's business, the longer sales cycle was compounded by an internal shift in emphasis toward company-owned DG systems that provide high-margin recurring sales. These sales produce lower up-front revenue, akin to a software company switching to a SaaS model. I think the company could have explained that transition better. When the recurring revenue ramps up, and PowerSecure converts some of its robust pipeline of large hospital and data center deals into backlog, I think investors are going to be breathing a lot easier.
As for Utility Infrastructure, it's an inferior, low margin business. I expect POWR to improve it or sell it. Signs currently point to improvement, following a press release in late June announcing an amendment of terms on a problem contract with a major customer. PowerSecure said it "believes these changes will restore the profitability of the work provided to this utility."
A side benefit of highly visible stock plunges is that they can draw activist attention. I wasn't the only one buying when the blood was running. Becker Drapkin filed a 13D on May 27, disclosing an 8.8% stake in POWR and stating their belief that "the shares of Common Stock are undervalued and represent an attractive investment opportunity. The Reporting Persons believe the assets of the Isssuer trade at a steep discount to intrinsic value. Recent operational issues underscore a need for discipline and focus in resource allocation." Based on those comments, my guess would be that Becker Drapkin will push for a sale of the Utility Infrastructure and/or Energy Efficiency divisions, but that remains to be seen.
To state the obvious, I agree with these folks about the undervaluation here, though the steep discount has narrowed a bit since May. The window of opportunity to establish a sub-$7 position was essentially four days. Interestingly, one could have taken the entire weekend to research and ponder, and then gotten even lower prices on Monday (day 3 of the plunge). Still, one had to act fairly quickly.
Present-Day Plunge #2: DXP Enterprises (NASDAQ:DXPE)
Industrial distributor DXP Enterprises reported Q1 results on May 12, 2014 and the stock tanked from $108.92 to $66.13, for a ~39% decline. While overall business was slow, the main culprit here was a recent large acquisition -- the biggest in the company's long history of consolidation through bolt-on M&A, at $293.6 million -- whose sales came in far short of expectations. Chairman and CEO David Little stated on the conference call that he felt misled by the sellers of B27, a pump and integrated flow control specialist, and estimated that DXP overpaid by $100 million, or roughly 50%. That's a pretty epic blunder, but does it justify the loss of over $600 million in equity value? My conclusion was, and remains, no.
Having purchased the business for $6 million in 1986, David Little has made himself and long-time shareholders a fortune over the years. Over the past 15 years, the stock has delivered better than 25% annualized returns, even after the plunge. That beats the pants off the likes of Fastenal (NASDAQ:FAST) and MSC Industrial Direct (NYSE:MSM). It's easy to dismiss companies that pursue a roll-up strategy, given how frequently such M&A-driven firms end up overpaying and overreaching. The highly fragmented industrial distribution space, however, is a great example of where consolidation makes all the sense in the world. DXP has executed a mix of organic and inorganic growth beautifully -- or at least it had until it bought B27. David Little remains optimistic about the purchase, saying on the call "It is still a great business. We may all be laughing about this in 2015, but it is not very funny right now."
Little's colleagues appear to be optimistic about the future of DXP as well. Following the sell-off, there was a raft of insider buying, including a 2,000 share purchase (~$130K) by Sr. VP David Vinson and an 1,100 share purchase (~$73K) by Sr. VP John Jeffery.
So far, no activist has emerged here. I think DXP could use a constructive outside shareholder, with the governance of the company in particular begging for a tune-up. The Board of Directors is simply not up to par for a $1 billion company. There are four Board members: the Chairman/CEO, an attorney, a reverse merger specialist who helped bring DXP public via a shell company in 1996, and a former DXP executive. I would like to see the Board expanded to at least five members, with the new addition being someone who is truly independent, i.e., with no prior relationship with the firm.
There is also more related party "stuff" than I would like to see.
I was particularly concerned about the hunting facilities that DXP leases from David Little for $150K/year. The 2014 proxy states that the company employs four people who work for Mr. Little at the facility, at a cost of $239K for 2013. In prior years, the proxy stated that the employee costs were netted against the rent paid, but this language disappeared in the latest iteration. I spoke to the CFO, who told me someone new drafted the proxy language this year, and it was simply an oversight. The cost to employ the ranch hands (the hunting facility is a ranch located several hours from the company's Houston HQ) comes out of David Little's paycheck, so there's no net outlay by the company in this arrangement. I pointed out the poor optics of the current wording in the proxy and expect that the language will be clarified next time around.
Nitpicks aside, this is a solid business run by a skilled owner/operator with a lot of skin in the game. The company stumbled with a larger-than-usual acquisition, but I do not think the growth model is broken. There are plenty of smaller bolt-on acquisitions still available, and DXP is not being forced to chase bigger and bigger deals. Having barely recovered since May, the shares remain attractively priced at around 13 times free cash flow.
Parting Thoughts on Buying the Plunge
To sum up, here are some pros and cons when it comes to buying the plunge:
- When panic selling hits, rational thought takes a back seat to emotions. Analyst downgrades and momentum-driven traders and algorithms can add fuel to the fire. This is a fertile hunting ground for mispricings.
- A large decline makes the stock in question look untouchable to many investors ("value trap," "sinking ship," etc.), reducing the pool of buyers.
- The window to act may last only a very short time, eliminating competition from both large funds and smaller funds that insist on reviewing years of SEC filings, reading every available transcript, and channel-checking the company's competitors, suppliers, and former employees before making a decision.
- The fall in price may have been from egregious levels. A big decline is no guarantee of undervaluation or opportunity. You have to be able to value the underlying business.
- Unlike a spin-off or other corporate action announced well in advance, there's not much time to do research. That can be an advantage, as stated above, but time pressure may increase the likelihood of making an error.
- A general "buy the plunge" strategy won't work, as the decline may be entirely justified by events. Each case has to be considered individually, requiring diligence and thoughtful analysis.
Ultimately, buying the plunge is not suitable for novice investors, but I would argue that with enough experience (in real-time or vicariously through case studies), this is a valid -- and valuable -- tool that belongs in any value investor's toolkit alongside spin-offs, divestitures, restructurings, and other special situations. I hope you'll share some of your own plunge-buying (or plunge-passing) experiences and lessons learned in the comments section.
Disclosure: The author is long POWR, DXPE. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.