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A Stock Market Horror Film: A Company Whose Stock Price Doesn’t Comply with Reality.

|Includes:Xyratex Ltd. (XRTX)
I have a theory about horror films: What truly frightens the heck out of so many viewers isn’t so much the disturbing and grotesque imagery – rather, it’s the fact that what appears on screen does not rationally comply with the world that we know.
Consider the following: In the film, Saving Private Ryan, the viewer witnesses the often-grotesque deaths of many soldiers. While these visuals might certainly be disturbing to some, they do not deliver the type of intense fear that interrupts the blissful slumbers of quite a few horror-movie-goers. And why should they? Though the images from Saving Private Ryan may not make us feel warm inside, we expect to see them. In real life, soldiers do perish on far-off battlefields. What we see makes sense.
What doesn’t make sense are the following visuals: a horrifically mutilated girl crawls out of television screens and turns perfectly alive human beings into perfectly lifeless disfigured corpses (The Ring); a child crab-walks down a flight of stairs at a frightening pace and vomits when she reaches the landing (The Exorcist); a children’s doll comes to life and brutally murders people (Chucky).
Get the idea? When expected things happen (soldiers dying) – no big deal. When unexpected things happen (scary girl crawling out of TV) – panic. What really scares us – what really jars our minds – is when things happen that just don’t make sense.
Often, the stock market is a veritable factory for this type of fear. Consider the following example:
Xyratex Ltd., (NASDAQ:XRTX) is a British data storage solutions provider whose six largest customers – NetApp, Dell, IBM, Seagate, Western Digital and Data Domain – are practically household names. By any rational analysis of its present financial condition, the company appears to be startlingly undervalued. The current consensus of six analysts expects Xyratex to earn $4.23 per share in FY 2010 on revenue of $1.6 billion. Given the company’s present share price ($11.49), this would equate to a P/E ratio of about 2.72 – or 2.26 if you back out the company’s $1.93 per share cash hoard. Granted, the analyst estimates for 2011 are not quite as rosy - $2.91 EPS on flat revenue – but even when one considers these less favorable forward projections, the company’s valuation remains shockingly low. Why then, does this company’s stock price languish at such low levels?
It just doesn’t make sense.

And that’s just it. When the recent stock market malaise began in late spring, this relatively unknown small-cap company seems to have been unfairly punished by the moody Mr. Market. What resulted was a dizzying 45% drop from the 52-week highs that Xyratex notched in April to the prices that investors see today. And when prices fall, investors tend to get scared.
“The stock price has gone down despite stellar earnings! Something must be wrong,” investors might reason. So they sell their stock, which, of course, lowers the price even more; this, in turn, creates more fear and induces even more people to sell their stock. What results is a self-reinforcing price depression that simply doesn’t make sense.
So how does it end? Well, if one trusts in the wisdom of noted investors Benjamin Graham and Warren Buffett, then the following conclusion to this stock market horror film seems realistic: At some point, the strong fundamentals of Xyratex will be made manifest in its stock price. Of course, there’s no telling when this may occur, but, for now, I am perfectly willing to wait until the end of this horror film.

Disclosure: The author holds a LONG position in XRTX.
Stocks: XRTX