The Different Types Of Value Stocks

|
Includes: AA, AAPL, AWK, KO, NSRGY, OUTR, PM, SAFM, WMT, YUM
by: John Zhang

Summary

Classic Compounding Stocks.

Cyclical Value Stocks.

'Cigar Butts'.

Antifragile Stocks.

Overview

Many value investors are familiar with the concepts of margin of safety, intrinsic value, recurring cash flows and other criteria which are essential to the investment process. However, there are different types of value stocks that require the value investor to adopt a different psychology and strategy when buying them.

The Classic Compounding Stock

Prime examples in this category include Coca-Cola (NYSE:KO), Nestle (OTCPK:NSRGY), Apple (NASDAQ:AAPL), Yum Brands (NYSE:YUM), Phillip Morris (NYSE:PM) etc. These are stocks that not only have a durable competitive advantage to their peers, but also a large presence and strong brand in the market which cements their staying power. Crucially, these companies also have strong pricing power that enables them to increase prices year after year, thus compounding returns for shareholders. Warren Buffett once gave the iconic example that if Coca-Cola were to increase its prices by one penny, it would rake in an additional $18M a day. In more recent times, Apple has demonstrated an uncanny ability to charge a sizeable premium for its iPhones, MacBooks and other gadgets compared to similar offerings by competitors.

The key to their success is the power of their brands and the market share/size of their operations. This enables them to raise prices, out-compete peers, penetrate new markets and scale profits extremely quickly. This can be achieved with a both diversified portfolio of products, as seen through the example of Nestle and Yum, or through a strong, concentrated portfolio, such as Coca-Cola and Apple in the early days.

These are essentially classic buy-and-hold stocks that will provide moderate to strong compounded growth over a long, long time. However, investors should be prepared to pay a premium for these companies due to the soaring valuations over the past few years and the quality of these companies.

The Cyclical Value Stock

These are companies with strong, healthy fundamental businesses operating in cyclical industries. They may appear extremely weak and vulnerable during an industry downturn, which then leads to an undervaluation of their shares.

A personal example I have come across is Sanderson Farms (NASDAQ:SAFM), a poultry producer and distributor.

A quick look at the 10-Year earnings chart and it becomes obvious that SAFM is a cyclical company. Due to the commodities cycles in corn, soybean and other ingredients used for poultry feed, SAFM's earnings are heavily affected by these fluctuating prices. Hence, the swings in its earnings reflect this reality.

Even though companies like SAFM makes losses during tough industry conditions, its earnings soar during periods of low input costs, allowing for extremely outsized returns. Moreover, when benchmarked to peers, SAFM consistently has higher margins and growth during industry upturns, and lower debt and losses during industry downturns when times are bad. This is crucial to determining whether a cyclical stock has a strong underlying business.

When investing in cyclical stocks such as Sanderson Farms, American Airlines (NYSE:AA) etc, investors should be prepared to hold these stocks for a long time. Also, investors may need to stomach losses for an extended period of time to weather the bear cycles. Hence, it is absolutely critical that these companies have strong balance sheets that would allow them to tide over the downturns. For Sanderson Farms, their debt to equity ratio is a measly 0.02, ensuring they have a strong financial base and cheap debt to draw upon during tough times.

The important thing to note with regard to industry swings is that timing the turns rarely works; even legendary investor Warren Buffett humbly admitted he can't time the market. Hence, a prudent strategy would be to buy when the stock is undervalued, and if an industry downturn comes, a value investor should drink some liquid courage, back up his/her judgment and buy more.

The 'Cigar Butt'

These stocks are like cigars with a few puffs left, but are trading at such a bargain that the last puffs are pure profit.

An example would be Outerwall (NASDAQ:OUTR), which operates Redbox movie rental kiosks and Coinstar machines. The business is in secular decline but generating a tremendous amount of free cash flow annually. Like most sunset companies, OUTR trades at an extremely attractive valuation with a P/E of 13.17 and a P/FCF of 5.53. When analyzing cigar butts, the trick is to figure out if the last few puffs are worth the price - are the remaining few years of free cash flow worth the price of the company now?

Using a simple example, let us assume OUTR continues to churn out free cash flow at the same rate for the next few years. By the sixth year, the total free cash flow generated would have exceeded the value of the company, and shareholders would be handsomely rewarded through share buybacks and dividends. Contrary to compounding stocks and cyclical value stocks, cigar butts are declining businesses that offer value purely on the basis of its cheap valuation and shareholder-friendly return policy.

The Antifragile Value Stock

A concept popularized by Nicholas Nassim Taleb, an antifragile stock is one that becomes more appealing and outperforms during periods of overall market turmoil and uncertainty. These companies usually offer necessities that are extremely price inelastic that have strong consumer demand even during periods of slow economic growth. Examples include utilities companies like American Water (NYSE:AWK).

Another type of antifragile value stock would be strong companies that perform well enough during normal market conditions, but have the ability to maintain earnings during an economic crisis. Examples include discount retailers like Walmart (NYSE:WMT) and tobacco conglomerates like Philip Morris . The key here is to identify which industries can continue to thrive during recessions, and to pick the best out of the bunch.

Conclusion

Whilst following the core principles of Value Investing ensures profitability, investors need to be aware of the different types of strategies necessary for different value stocks. This would allow us to minimize losses and maximize gains.

Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in SAFM, AAPL over the next 72 hours.

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.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.