The Art of Finding Fallen Angel Stocks

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 |  Includes: AAPL, DIA, GM, QQQ, SPY
by: Joe Ponzio

Folks — as you can imagine, I have been busy ripping through annual reports and financial statements like crazy. Hence the irregularity to my posting. Back in October of last year, I had a lot of time on my hands — the effects of a high market and few opportunities. That situation has reversed.

What am I looking for? The economy has been putting a squeeze on a lot of companies, slamming profit margins, revenues and earnings. When this happens, companies have to start shedding assets — human and physical — in an effort to return to normal levels of profitability. When profit margins are thin, the business' are at risk (think GM, Blockbuster). When profit margins are fat under normal conditions, the business is sound, even if it takes a substantial hit to sales.

So-called "bottom feeding" is the art of finding deeply discounted businesses that have a high probability of returning to "normal" conditions (ie., normal profit margins, normal owner's margins) when the dust settles. That's where you will find tomorrow's winners. (Note: This is also why quality of management and high owner's margins are so important. Bad management won't know what to do; thin profit margins can be too tough to overcome.)

It's far easier to tell what will happen than when it will happen.

Today's markets are a test of all the value investing reading, studying, and learning you've been doing over the past (days | weeks | months | years). When the markets are on the rise, it's easy to call yourself a value investor, pick a stock you think is underpriced, and make money. The true test is when the markets drop and you have the conviction to look at a business, figure out its worth under "normal" conditions, put your money to work, and then close your internet browser for a while.

And watch out for bonehead moves. It's easy to lose sight of the long-term when your portfolio is dropping a few percentage points each week. Don't play the markets unless you are 100% sure. When the Dow was at 13,000 last month, you could be pretty sure that it had topped out. (If you weren't sure, forget the rest of this discussion.) At that point, you could have purchased puts on the markets or otherwise taken advantage of some of the irrational exuberance. (The "Phew, that was close. Glad it's all over." sentiment on Wall Street.) In May 2008, the Dow 13,000 was way too high — I told a friend not to be surprised to see Dow 11,800. Now at 11,200, I have no idea whether or not we are oversold — I can't call a bottom nearly as clearly as I can see a top (at which my vision is murky at best).

GM at $10 a share? People are acting stunned. Five months ago, it was a $29 stock. But the threat of bankruptcy — or at least a very severe scaling back — was just as great then as it is today. I tried to short it but the nice people over at TD Ameritrade informed me I couldn't — that they didn't have any shares in inventory. (I guess TD Ameritrade clients don't like GM.) I know I said Don't Go Short on Overpriced Companies, but the GM play was entirely different. Read on:

When Apple (NASDAQ:AAPL) was a $150-$160 company last year, shorting it at $186 would have been very risky — how could you have known whether the price would remain flat until value caught up or the price would drop to a level more commensurate with value? Shorting Apple, you're betting on the "when" instead of the "what". With GM (NYSE:GM), nothing but a miracle could have helped the business. In this case, I wasn't betting that GM's price would fall (the "when"); I was betting that GM's business would fall (the "what"). The price would eventually follow the value — in this case, practically none. (It's very similar to Ken Heebner's shorting of Countrywide last year in the high $40s.)

What's the point? Find what Wall Street calls "Fallen Angels" — great businesses that have fallen in price due to some temporary disruption, but that should return to profitability or "normalcy" in the next few months and years. Keep an eye out for "Falling Knifes" — businesses that are suffering (or are expected to suffer) so greatly that recovery is contingent on miracles or a very severe scaling back. Bet on what you know will happen; don't worry about the when.

To those of you whom have asked for the "owner earnings vs. free cash flow" email, I'll get it to tomorrow. Sorry for the delay; I just found it again last night.