Waking Beast:

This is where things begin to get exciting for us. For some reason these stocks are significantly undervalued (selling well below their Intrinsic Value), yet there is nothing necessarily wrong with them. For the most part they might be growing at a good pace, have a good management team and a product that is in demand.  Yet, the market has sold them off.

There might be a number of reasons. The industry itself might be going through a downshift, there might be a bubble elsewhere in the market and it sucked up all the capital, there might be a misconception about the company or they are simply not sexy enough.  

Home builders in early 2000’s would be a perfect example of that. At the time they were selling at huge discounts to their Intrinsic Value even though the housing boom was in full swing. Most of the companies in the industry were selling at 30-75% discount to their Intrinsic Value even though people were literally fighting and standing in lines to get access to their products. Their financial positions and management teams were superb as well.

These are the types of opportunities value investors should be excited about. The company is doing great on every front and is substantially undervalued, yet for some reason the market has discounted it well below what it is worth. Now that you have your margin of safety built into your purchasing price it is highly probable that these stock will appreciate significantly over the next few years or months to fully reflect their Intrinsic Value.

In conclusion, that is exactly what you are looking for.  Highly discounted stocks that are doing very well and are position to appreciate significantly over a short period of time. That is how you minimize your risk while maximizing your gains. Unfortunately, you won’t find many of these stocks out there. When you do, start buying.  

Rocket Ship: 

These stocks won’t come across your desk very often, but when they do you will be able to make huge sums of money. As Warren Buffett so famously says, “Wait for the perfect pitch”. Well, these are your perfect pitches. These stocks are dirt cheap, but they shouldn’t be. It could happen for two reasons.

1. The market has a misconception about the stock and has misprices it significantly. Yet, your fundamental research clearly shows that the market is wrong and the stock should bounce back soon.

2.  There are adverse market forces (like a severe bear market(2007-09)) that drive great companies well below what they should be worth. Eventually the market recovers and you make huge sums of money.

These are the companies that are doing everything right. They have strong financials, a great management teams, a great future, new products, etc… Yet, the stock price was driven down well below Intrinsic Value of the company. If your fundamental analysis confirms that the decline was unjustified and the stock should rebound soon, buy as much as you can. These types of investment opportunities will be your large money makers.  Don’t forget to look for the catalyst as well. Something that would set the climb in motion.

(A word of caution. Just as I talked about in the Dead Man Walking category, make sure you are not missing something. Make sure that your fundamental analysis didn’t miss an important point that the market sees and you don’t. )

To be continued….

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Hungry Dogs:

These stocks tend to operate in the no men’s land. They are not dead enough to file for bankruptcy, but are not healthy enough to do anything but survive. More likely than not they have significant business problems associated with their business. They are surviving, but barely so. Think of them as street dogs running around looking for food.

They either can’t or do not have enough capital to fix whatever problems they have. They are simply getting by and there is no catalyst on the horizon that would indicate that their luck is about to change. Typically they sell at a significant discount to their Intrinsic Value (or perceived IV). To the tune of 50-80%.

As an example, think of an apparel retailer who has been struggling over the last 5 years. Their brand name has been diminished, their sales are down 4-5% quarter after quarter, there is no new store growth, their management is not changing direction, they are sustaining operating losses, there are no interested parties in buying them out, their financial position is very weak and they barely have enough cash flow to keep their operation going.

The bottom line is, avoid these stocks if there is no clear catalyst that could increase their value in the near future. What kind of a catalyst? As per example above it could be a buyout or a takeover, management change, improvement in merchandise, gradual/consistent improvement in same store sales, new store openings, etc….. 

If no clear catalyst is present, these stocks are likely to remain in their trading range or worse, shift into the Dead Man Walking category. As such, you don’t want to tie up your capital in such stocks even if the margin of safety is over 50% and your valuation work suggest otherwise.  Simply put, these stocks are not going anywhere.

Sleeping Beauty:

Just like a sleeping beauty these stocks are nice to look at, but most of the time they are worthless. Such stocks might look very good in your overall portfolio, but what is the use if they do not contribute to your capital gains. They are certainly better than Hungry Dogs, but not by much.

They are easily identifiable through the following characteristics. The company is growing at a slow rate of about 1-5% per annum. It is financially stable, operating at a profit or a small loss, has enough cash flow to sustain operations for a long time and in no imminent danger from outside factors. Furthermore, the company is making certain changes that seem to be working, but they are not drastic.  The company is selling at a significant discount to its Intrinsic Value (20-70%), but its stock price hasn’t gone anywhere over the last 5 years. Plus, there is no clear catalyst to release the value in the near future.

As an example, such a company might include an agricultural company with a lot of land holdings or a REIT that has a lot of assets, a strong financial position, but no real catalyst for releasing that value to the  shareholders. Their stock prices end up stagnating, sometimes for decades even though investing in them looks good on paper.

In summary, you want to avoid these stocks as well. They might  look good, but all they will do is tie up your capital for a long time without any sort of a real return. Meanwhile you might be losing on other great investment opportunities. The opportunity cost is real and you should definitely take that into consideration when looking at sleeping beauties. 

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Warning: Not All Value Stocks Are Created Equal

 

Now that you are well versed in value investing, the concept of margin of safety and how to do Intrinsic Value calculation work, you must be made aware of yet another very important point.  

Not all value stocks with a substantial margin of safety are created equal.

For example, you will have companies selling well below their intrinsic value, but on their way to an eventual bankruptcy. You will have stocks selling very cheaply, but with no chance for a recovery any time soon. You will have stocks that seem to have a large margin of safety, yet it is an illusion. You might have stocks that offer very little margin of safety, yet they are about to take off to the upside like a rocket ship to the moon.  You get the idea, many  outcomes are possible here.

For my own purposes, I like separating Value Stocks into the following easy to remember categories…..

Dead Man Walking:

Initially these stocks might look like a great investment opportunity because they are selling as if they are about to go out of business and/or file for bankruptcy.  On the surface they might be everything a good value investor is looking for. They might selling at a huge discount (80-90%) to their Intrinsic Value and you might be salivating over the opportunity, thinking about how much money you are going to make.

However, stop for a second and take a closer look. It is very rare that a market will present you with such wonderful buying opportunities. It will happen, but very seldom. Most likely than not, you are missing a vital piece of information that the market sees.

You will need to go back and figure out if this a great investment opportunity or if this is a company that will be filling for bankruptcy 6 months from now.  

You will need to be very careful here. You will need to double down on your fundamental research and figure out what you are missing. I guarantee, you are missing something. Once you find that missing part you will need re-evaluate your fundamental research and Intrinsic Value calculation in order to determine if your original conclusion was right.

If you still believe in your original conclusion, I recommend that you buy as much as you can. You might have found one of those once in a life time opportunities.  

At the same time, if the missing piece of information makes a significant negative impact on your previous work you would want to steer clear of this stock.  

Conclusion: Typically you want to avoid these stocks like a plague. They are cheap for a reason. They will stay cheap for a long time or will soon file for bankruptcy. Yet, if your fundamental research continues to confirm your original research you might want to shift this stock into a Rocket Ship category. 

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