“Cheap” is Different from “Undervalued”

My investment advice can be summarized one word:  valuation.  Through painful and expensive lessons in more than a decade of investing, I learned that when you buy “popular” stocks that everyone knows about, you get burned badly because they inevitably become overvalued.  It’s the function of the law of supply and demand.  When everyone’s buying the same thing, the price rises above its value.

One way to find undervalued stocks is to look for companies that are under the radar.  This is not easy to do precisely because few people know about them; to do it successfully would require a lot of time.  One recent stock I bought was a result of a whole’s day’s worth of research into an industry that was wholly unrelated to the stock I eventually bought into.  I felt confident about my choice and, lo and behold, the company was acquired three months later for a 30% premium.

The easier way to find “undervalued” stocks is to go hunting for well-known stocks that have fallen out of favor.  Recent examples include companies like Citigroup (C), General Electric (GE) and British Petroleum (BP).  In the past, there were companies like Apple (AAPL) and Edison International (EIX).  These are companies that even the casual investors have usually heard of but, for one reason or another, the stock has or had taken a beating.

All of these stocks are or were “cheap” relative to its historic prices.  Indeed, they are or were often “cheap” compared to rest of the market as they underperformed the broader indices and even peers in their industry.  The charts of these stocks show an arrow that is, for an investor who’s already bought in, heading in the wrong direction.

The pitfall of this bargain-hunting approach is the rather obvious observation that the stocks are or were cheap for a reason.  British Petroleum took a beating because of anticipated costs associated with the Gulf Coast oil spill.  Citigroup and General Electric tumbled because the entire financial industry was melting.  Apple was cheap because no one wanted to buy its products.  Edison International collapsed because the California energy crises put the company on the brink of bankruptcy.   These company or industry-specific issues drove investors to abandon these companies because they were potentially fatal to the company.  The stocks were cheap because the company was or was potentially worth little.  Worthless companies should be valued at worthless prices.  That’s not undervaluation; that’s just cheap for a reason.

Hence, one way to tell whether the stock’s fall in price is driven by valuation or undervaluation is to see if the fall is driven by company or industry specific events.  3M Company (MMM), which makes daily consumer products like scotch tape and post-it notes, crashed 30% as the rest of the market took a tumble in late 2008 into March 2009.  3M was affected by a bad economy and the frozen credit market like every other company, but there was very little news specific that was driving its stock down.  If you were confident before the fall that the company was fairly valued, then the stock going down in sympathy with others should have signaled a buying opportunity once the market calmed down.  And it did. You don’t get too many opportunities to buy a blue chip like 3M at a steal, but March 2009 certain provided that opportunity.  The stock has nearly doubled since.

A comparative lesson in valuation is Pfizer Inc. (PFE) during the same period.  While the stock similarly tumbled during the financial crises, it hasn’t gotten the same level of bounce.  In fact, its chart, which shows an increase in stock price since March 2009, are rather deceiving because the company has cut its dividend by 2/3 to pay for a major acquisition, significantly eating into shareholder’s annual return.  Those who were paying attention would know why Pfizer is underperforming relative to 3M:  it not only faced issues that were common to all companies, a bad economy, but also of its own doing, namely, lack of drugs in their pipeline.  If the company has nothing to sell even if the economy improved, the stock would justifiably fell.  The stock may have gotten cheaper, but there’s no immediate value to capture as the stock reflects the health of the company.

What really complicates the analysis is that there are rare cases when stocks that takes a beating because of valuation remains, nonetheless, a good value play.  At its trough, Apple was trading at $15 a share.  The company was going nowhere, and there was little reason to think it was going to improve.  But a keen investor would have noticed–as a prince in Saudi Arabia did–that the company’s book value was $12 a share, meaning that the market was valuing the business of Apple–and not the assets–at $3 a share.  Whatever doubts you may have had about the company’s survival as an independent entity, the odds were pretty good that someone would have been willing to pay more than $3 for the business.  A more recent example was Napster Inc., which had essentially lost battle over online music to Apple’s iTunes but still sat on significant amount of cash.  It was eventually acquired for a signficant premium over its stock price by Best Buy Co. Inc. (BBY).

The morale of this story is that value hunting is not as easy as chasing stocks that have tumbled–or avoiding it.  It takes a discerning eye to determine the cause for the fall and whether that fall results in appropriate valuation or provides an opportunity.  It’s not an easy exercise.  To a casual observer, Pfizer looked like it was falling with the market and Apple looked like it was definitive loser.  Alas, determining value requires the work that I preached a while ago, that you need to invest significant time in understanding the company and the stock, something you should be doing regardless of your investment strategy.

*  Full disclosure:  I hold long positions on AAPL, EIX, PFE, GE and MMM.


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