Here are some of the rules I’ve learned keep me out of trouble in investing in turnarounds and value stocks.
1. Patience Will Keep You Out of the Value Trap. Good value-oriented investors buy stocks later than their peers, while good growth-oriented investors sell stocks earlier than their peers. Waiting for your price is frustrating and boring. However, it is vital to remain patient in buying and holding stocks.
2. Stocks take much more time to move than you think (a corollary to the Patience rule). Companies and stocks that have problems but are generally well liked, take forever to fall (Drug stocks are a recent good example of this). Companies and stocks that are improving but are hated, take forever to rise. Investors love and hate stocks – it takes time to change their minds. This gives the patient an advantage. There’s always time to buy an improving stock or sell a deteriorating stock, even after it has already had an initial move. Often times, the first positive surprise after a long drought is considered a fluke and disregarded. After an initial “pop” the stock comes back down and trades sideways. However, the stock slowly starts being accumulated by value buyers and contrarian investors, which provides some downside protection. This method should protect you from getting in too early but keeps you from being too late and having to pay up for a stock after it’s already moved higher. Often times the analyst reports will say things like “Better than expected, but retain Hold rating” or “Good quarter, but risks remain.” Those are the reports that grab my attention because most sell side analysts don’t have the spine to upgrade a hated stock that has been beaten down for so long.
3. “Be fearful when others are greedy, and greedy when others are fearful” is a great quote from Warren Buffet. However, as all things in life, the execution is more difficult than the concept. To do this, you have to have the courage to raise cash in strong markets and put cash to work in weak markets. You should sell stocks as they increase in value, hopefully giving you a “cash-cushion” at the market top, to be deployed at the market bottom. Use valuation and market sentiment as a market timing tool – when you can’t find many good ideas to put money into, it usually means that there aren’t any and the market is at a top…and vise versa.
4. Analyze the stock and the business model separately. A business might be great but the stock a terrible investment because it is overvalued, or vice versa. Therefore, I want to buy good business models that are temporarily depressed in value because of fixable operational issues or temporary problems. There’s nothing more frustrating than owning a great company stock but having it go down every day because of “multiple compression” or other “non-tangible” factors.
5. Analyze stocks as if you were buying the business, but realize that stock prices reflect human emotions of greed and fear. While I always have an idea of the intrinsic value of a business, I am cognizant of the fact that stocks are pieces of paper that could turn into gold or goat food, depending on the whims of the market. While I don’t trade often, if prices rise to significant levels over intrinsic value, I sell. If they go below intrinsic value I buy. Easy. The hard part is when this happens within the span of a month or a quarter instead of a year. However, the time span should make no difference. Don’t hesitate to buy, sell, and buy again.
6. Buy or sell stocks on an incremental basis. One of the biggest mistakes you can make is to assume stocks will fall quickly or, after declines, that they rebound quickly. Things always tend to move higher or lower than you think possible.
7. The bad news is usually never “in the stock” until the business press or (even better) the main street press widely covers the problem. Things like accounting problems, major earnings shortfalls or other bad news is usually never discounted until you can read a story about it on Bloomberg or the stock has had a major “gap” down when the news is revealed. Even if it seems all the analysts, investors and Herb Greenberg know about the problem, it’s still probably not in the stock unless the problem is revealed in the press. Especially troubling are the revelations of problems when a stock has a high, or relatively high, multiple. Most analysts will encourage you to ignore the issue and/or make the case that it is not significant. However, to support a high multiple, a company has to be perfect. Therefore, never ignore new problems that are mentioned casually on high multiple stocks. The analysts will all re-iterate their buys but unless the company is hitting on all cylinders, watch out for “multiple compression.” Until you read about it in Business Week, there’s usually still time to get out of a stock since it takes longer than you think to get the news discounted. There are always more “hangers-on” than you think.