Value Investing 4: Revulsion

by: Philip Mause

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The next topic in this series is one which will identify likely sources of value investment targets. Because prices of securities are set in a marketplace, price levels are affected by investor sentiment and, at its extremes, this sentiment can produce sharply underpriced opportunities. Unfortunately, these opportunities are often the very stocks and bonds that an investor will feel most uncomfortable purchasing. I use the word, "revulsion," because the best opportunities are often those which are least popular among investors and can even elicit groans and moans when suggested as possible targets of opportunity.

A value investor demanding a "margin of safety" almost always takes the position that somehow "the market is wrong" and an investment choice is wildly underpriced. While I do not adhere to the "efficient market" theory, I also believe that, in the modern stock and bond markets, there is a great deal of publicly available information, there are many very sophisticated players, and prices generally correspond with value. When I think I have found a possible exception, it is helpful to be able to identify a plausible rationale for the thesis that "the market got it wrong" and the asset is underpriced. Here are a few examples of situations which have arisen and will arise and which tend to create value investment opportunities.

1. Asset Class Redlining - There have been situations in which an entire asset class produces such investor revulsion that any security in the class is likely to be indiscriminately discounted regardless of its individual merit. The best examples of this are the high yield or "junk" bond market in the early 1990s and, again, in 2008-09. For years and years, junk bonds were a disfavored asset class. Michael Millken came along, did some calculations and demonstrated that investors in junk bonds generally outperformed other fixed income investors because the high yields on the junk bonds more than compensated the investor for the additional risk of default. In the 1980s, there was a wave of junk bond issuance and the asset class became much more popular. By the early 1990s, this wave had reached levels of excess and Mr. Millken was living in Club Fed. There were some nasty defaults and investor revulsion set in. A careful analysis revealed many situations in which the discount on certain bonds was all out of proportion to any risk of default. My favorite story involved Chrysler. In the early 1990s, a broker called me and recommended Chrysler stock: the company had had a few good quarters and prospects were looking better. I asked him what he thought about the bonds, which were yielding about 25% and I will never forget his answer - "I am recommending the stock. I would never recommend the bonds; they are junk bonds and they're too risky." It was pointless to argue that, if the bonds went into default, the stock would be worthless. The "junk bond" label on a security condemned it to exile from polite conversation. A similar situation arose in 2008-09 when spreads opened up to and beyond levels last seen in the Great Depression. All sorts of bonds of major, stable companies were trading at ridiculous yields. I sometimes think that all an investor has had to do over the past 30 years was to stay in cash at all times except the early 1990s and 2008-09 and to buy junk bonds during these two brief intervals. Unfortunately - or perhaps fortunately - the junk bond market no longer offers these extraordinary opportunities. Of course, the opportunities arose at precisely the time it felt most frightening to invest.

2. Guilt by Association - Sometimes, serious problems experienced by one or more stocks in a sector can lead to an indiscriminate sell off of the entire sector. In an era increasingly dominated by ETFs, this is likely to become more of a pattern. In 2008-09, problems experience by American Capital (NASDAQ:ACAS) and Allied Capital - now part of Ares Capital (NASDAQ:ARCC) - led to investor distaste for all Business Development Companies (BDCs). Since a good part of the problems Allied and ACAS had were associated with disputes with lenders, one might have expected that BDCs with no debt - like TICC Capital (NASDAQ:TICC) - would have held up well but, in fact, the entire sector tanked and it was relatively easy to identify BDCs with no debt or with such minimal debt that lender problems were unlikely and pick up the stocks at deep and unjustified discounts. Another example occurred in the 1970s when Consolidated Edison (NYSE:ED), the electric utility serving New York City, suddenly reduced its dividend. Because dividend oriented investors tend to be important owners of electric utility stocks, a panic set in and, not only ED, but also the entire utility sector tanked. ED's reasons for cutting its dividend were idiosyncratic and had nothing to do with other utilities which had different regulators and different construction budgets.

3. Dividend Omission - When a stock is owned largely for its dividend yield, an omission or a reduction in the dividend can have devastating effects on the stock's price. While I am not sure I agree with the frequently stated thesis that dividends should be irrelevant to valuation, it is also clear that the reaction to dividend reduction can be overdone. In the Fall of 2009, Cedar Fair (NYSE:FUN), a real estate investment trust (REIT) which operates amusement parks (which may be the ultimate wide moat business) cancelled its dividend in order to build up cash for an upcoming payment to its lenders. The stock was absolutely crushed to such an extent that a takeover offer well above market materialized a couple of months later. The stock had clearly been driven down well below the company's private market value. There was a battle over the takeover attempt and the stock has recovered to levels higher than those which prevailed prior to the dividend cut.

4. Chicken Little - A perception that "the sky is falling" can lead to such a massive sell off that a careful investor may find that the discount that has opened up is overdone and more than compensates an investor for the risks of catastrophe. Early in the last decade, a number of stocks were absolutely obliterated by the threat of asbestos liability. Haliburton (NYSE:HAL) and Georgia Pacific were two companies which faced this liability but had solid businesses and began to trade at deep discounts to the prices of other similar companies. While asbestos is nasty stuff and asbestos liability had sunk other companies, litigation had reached the point at which some reasonable estimates could be made about per case expected cost and these companies were clearly priced based on unreasonably bad assumptions. Both stocks recovered nicely and the asbestos scare proved to be a golden opportunity to buy in at an attractive price.

5. Investor Fatigue - Sometimes, investors tire of losing money and the accumulated frustration engendered by false starts, broken promises, capital losses, and bad news leads to such negativity that the market cannot react to positive developments. I think that the megacap tech stocks - Microsoft (NASDAQ:MSFT), Intel (NASDAQ:INTC), Cisco (NASDAQ:CSCO), Dell (NASDAQ:DELL), Hewlett Packard (NYSE:HPQ) - may be in this situation now.

In all of these situations, astute investors should have been able to discern that the market had underpriced certain securities. What is sometimes much harder to discern is when the market will "get smart" and price the stock at its "fair" price. In this regard, the high yield bonds were the easiest investment. An investor could be indifferent to the market and simply collect the yield (often as high as 25%) on the bonds. If the investor had correctly assessed default risk, he would make a lot of money regardless of how long he had to wait for the bonds to trade up. In the situation of FUN, a takeover attempt provided the "catalyst" for the price to trade back up and it ensued rapidly. The BDCs were a bit like junk bonds and provided an investor with generous yields as prices moved back up to more rational levels. The megacap tech stocks are probably too big to be taken over and with a couple of possible exceptions do not pay an investor to wait. In a future article, I will discuss why I still believe that many of these stocks are undervalued and what I think the catalyst for higher prices will be.

Disclosure: I am long ARCC, ACAS, TICC, CSCO, ED, MSFT, HPQ, INTC, FUN.