Take Advantage of Crazy, Paranoid Mr. Market

Bear markets and recessions bring out the Crazy, Paranoid Mr. Market instead of the Happy Go Lucky, Greedy Mr. Market.Crazy, Paranoid Mr. Market does not want to own certain stocks or asset classes at any price; he is selling indiscriminately without looking back. Greedy, level-headed investors would be wise to take notice when Crazy, Paranoid Mr. Market is running to hide. There are opportunities ripe for the taking.

During the last recession in 2002, the small internet companies were the investing toxic waste that no one wanted to own. If you can remember back to 2000, virtually every investor in the U.S. was overweighted in technology stocks with a heavy bent toward the internet. By 2002, most of these stocks had fallen 70% to 90% and most Americans had felt that pinch. Any reminder of those days was painful, and so most investors had purged their portfolio of anything internet-related and they did not want to get back in. However, for a few of us, this represented a huge opportunity that we could not pass up.

The biggest value was in the small unknown internet companies, many of which had just gone public in 1999 or early 2000. At the time, many of these companies were trading at or near their net cash value (cash per share less debt per share). In other words, if they had net cash on the books of $1.00 per share, they might have been trading at $1.25 or $1.50. Most were losing money, but there were a few that were just turning profitable or very close.

I analyzed the business models of many of these small internet companies and invested in two that I thought offered the best risk-reward ratio; Ask Jeeves and Varsity Group. Ask Jeeves was a search engine company that had recently turned profitable and was ranked 4th or 5th in search traffic. They were later acquired by Interactive Corp (IAC) in mid 2005. I bought Ask Jeeves in October 2002 at $1.44. I was buying a company with cash on the books (between $0.50 and $.75 per share) that had just turned profitable. They had a good profit model that was going to show significant earnings momentum in the coming quarters.

The stock sailed upward during the next year reaching $17 by October 2003. I sold in 4 traunches during the next year at various prices, but my blended sale price was $7.39 per share, for a 500% cash on cash return.Varsity Group had a different internet model that was equally intriguing at the time. They were creating online bookstores for small private schools and colleges as an outsourced service. They also had just turned profitable in late 2002, but they also had over $1.00 per share in cash on the books.

I bought Varsity at $1.46 per share in December 2002.Varsity's earning growth was not as explosive as Ask Jeeves, so their stock appreciation was slower. Over the next 2 years the stock rose and peaked at about $8.00 per share in January 2005. Unfortunately, I hung on to most of my shares too long with Varsity Group. The company later went on an acquisition binge and changed their model for the worse. I still ended up selling my shares in 3 traunches for a blending 45% return.

I do not relate this story to show you how smart I am, because I have also had my share of losers such as Krispy Kreme Doughnuts. However, my point is that we are in another one of those markets where Crazy, Paranoid Mr. Market is selling certain stocks indiscriminately. There are many stocks at ridiculously low valuations because of indiscriminant selling in certain industries, including retail, home improvement manufacturing/retailing, financial services and Chinese companies listed on US Exchanges.

I have not purchased any of the home improvement or financial services companies yet, but I am starting to look.On the retail front, I recently bought one stock that is trading for less than 3.5x EBITDA and at those prices, I predict the private equity groups will come calling. I also own one restaurant stock and one retail entertainment company, both of which I love at current valuations. Lastly, I own a Chinese stock that trades on the NYSE but that is underfollowed and trading at a Forward PEG of 0.43, meaning that its PE is 43% of its growth rate vs the more typical 1.5x to 2.0x PEG ratios of growth companies. Check out my personal blog for the specifics on these companies.

Comments

[globalmacro]

There are quite a few strong opportunies amongst the growing legion of NYSE traded Chinese stocks. These stocks did not receive nearly as much hot money as the A share market and some sectors, like online multiplayer games, are trading like value stocks even though they have 70% operating margins, half of their market cap in cash with no debt, 100% growth rates, and forward PEs of under 20.