7 and a half ‘Good Reasons to Buy a Bad Company’
Originally posted on Convergex.com
Summary: All the good ones are taken. After six-plus years of a bull market in U.S. stocks, great companies tend to have equally great valuations and wide followings. What’s left – the names that aren’t working – are cheap for a reason. Or many reasons. Yet in that slurry must be some gems. Today we consider a checklist of potential investment catalysts to help separate the genuine turnarounds from the stuck-in-the-muds. High on the list: new management, anticipated breakups/spinoffs, and industry-wide rationalization. Low on the list – and with a cautious bias – is the presence of an activist investor demanding only stock repurchases. And one reason that should never be the sole basis to buy the stock of a troubled company: valuation
There are some 53 companies in the S&P 500 that are down more than 20% over the last year even as the market as whole is up 7.2%. Just over half of them are in the Basic Materials sector, which includes many energy names. Easy enough to understand how they ended up in the dog house – the sharp decline of oil prices late last year dramatically reshaped the earnings profile of these companies. The second largest group of red-numbered stocks belong to Industrial names that by and large service the energy sector. After that come a series of one-off stories in the Consumer and Tech spaces. Makers of fashion-sensitive accessories or high-priced coffee machines, for example.
What’s remarkable about this list is just how many “Good businesses” are passing along lousy returns to their investors. No one doubts that “Big Oil” or manufacturing large and complex earthmoving equipment are fundamentally decent businesses over a cycle. Selling popular, if perhaps slightly overpriced, handbags has rarely driven business owners to the poor house. There’s even a well-known casino operator down +45% over the past year. No one has rescinded the law that says “House always wins”.
There are big differences between a bad stock and a bad company. The former is often a function of an unforeseen macro event combined with valuations that become stretched on the up cycle and then break as investor euphoria diminishes. Casinos are a good business, but the Chinese casino business has some challenges just now. Oil is a good business, unless you view the world solely through the eyes of a conservationist, but a 50% decline in oil prices is going to hurt even the largest and lowest cost producers in the near term. “Bad companies”, by contrast, lose money over a cycle or, best case, make too little in the way of returns on capital to compensate their owners for their investment.
“Good industry/company” and “profitable sector/stock to own” don’t have to be the same thing either. I covered the auto industry from 1991 to 2003, as both a brokerage analyst and portfolio manager, so I know a bit about lousy industries and the companies that inhabit those rabbit holes. I mention that mostly because Sergio Marchionne, the current CEO of Fiat Chrysler, recently gave a presentation entitled “Confessions of a Capital Junkie” where he outlined just how bad a business the global auto industry has become. Spoiler alert: it’s been bad since the 1980s. Overcapacity and rising capital requirements have been the crumbling cornerstones of the industry since Honda opened its first auto assembly plant in America in 1982 and GM decided to counter with its Saturn small car operation just three years later. Hope springs eternal in the auto industry, even if decent profits seldom follow.
And yet, there has been good money to be made over the years in auto stocks. Ford Motor Company, for example, bottomed in late 2008 at less than $1.50/share. It now trades for close to $15. American Axle troughed at $0.70 about the same time as Ford, and closed today at $20.70. Even after a pullback from $26 earlier this year, that’s an obviously outstanding return. You can actually make very good money in a very bad sector.
Now, there’s obviously a method to the madness of finding these outsized returns. Here’s a cheat sheet for finding the intersection of “Bad company” and “winning idea”:
Cyclical Upturn. That’s the magic behind the historical returns at Ford and Magna, of course. Car sales have improved by +50% from the cyclical lows of the Financial Crisis and that helped first assure ongoing viability and then boost earnings and cash flows. In practical terms, this is the easiest intersection of “Lousy industry” and “big returns”. The global energy industry is shaping up to be this year’s big cyclical trade. You’ll just need a strong stomach to load up at the right time, because it truly is darkest before the dawn.
New Management. Going back to the early 1990s but staying in the auto industry, Goodyear Tire was one of the big winners of the 1990s automotive cycle because the company’s Board brought in Stanley Gault to run the place after a brush with bankruptcy in mid-1991. Gault had turned around Rubbermaid in the 1980s, and dramatically expanded Goodyear’s retail footprint by selling through Wal-Mart, Sears and other third party retailers. That incremental demand, plus the turn in the U.S. economic cycle, took the stock from $8 in 1990 to $75 in 1998.
Industry Rationalization. If there was a worse structured sector than making new cars and trucks from the 1980s to 2009, it was likely the airline industry. Old timers will recall the usual cadence of earnings estimates for any company in the sector as ranging from a loss of $10/share in year one, breakeven in year two, and making $20/share at the top of the cycle in year 3. Now, with industry rationalization finally complete – at least for U.S. carries – United Continental has gone from $3 in June 2009 to $56 today. Flying may be a miserable experience, but at least all those full flights show that industry rationalization has finally worked.
Breakup/Spinoff. In most “Bad companies” there are still “good” operations. Even the auto companies have their jewels in the form of pickup truck businesses that generate virtually all the profits in many years. Now, GM can’t sell off GMC truck assembly, but troubled companies can improve their value by selling underperforming operations. The big trick here as an investor: look to see where the management goes in a breakup or spinoff. They know more about the opportunities in each business than you.
Bad Company as Acquisition Target. Animal lovers know the saying “There are no bad dogs, just bad owners.” The same is true for companies. For years I covered a large tire and battery distributor based in Memphis. They had serious economies of scale, for they controlled 6% of the market for replacement tires in the U.S. and had a million square foot warehouse to show for their efforts. But selling low end private brand tires is a tough business. Pricing power? No. Unit volume growth? Not so much. They ended up selling to a foreign tire maker anxious to gain market share in the U.S. for roughly twice the current share price, as I recall.
Fixing the Balance Sheet. Sometimes it’s not really the company that is “Bad”, but rather the company’s mix of debt and equity financing. Yes, corporate finance theory says this isn’t supposed to matter. But sometimes it does, as when the debt burden calls into question the sustainability of the business through a cycle. Or when the company needs fresh financing to take advantage of acquisition opportunities. In those cases, redeploying all available operating cash to debt paydown, plus asset sales to give that repayment a further boost, is an excellent way to solve the problem quickly.
(Very Rare) Bankruptcy/Workout Opportunities. Never doubt that the automotive industry, broadly defined, is a one-stop shop for every single “Troubled company becomes great investment story” you’ll ever need. In June 2003, AMERCO files for Chapter 11 bankruptcy. AMERCO owns U-Haul, the self-moving business. Because one family owned the majority of the stock, they had a strong incentive to retain some equity value even through bankruptcy. The reorganization worked, and the stock went from $4, split adjusted, to just over $329 today. Even famed investor Wilbur Ross didn’t think the stock would be worth anything substantive. Quoted in a 2003 New York Times article about the company CEO talking up AMERCO’s stock to investors, Mr. Ross said “It does seem to me that flogging his stock is not the best use of his time”.
And... Activists Getting Involved (Sometimes). Make no mistake – a good activist is worth 1,000 brokerage “Buy” recommendations, especially when they have a proven track record and a serious game plan for their involvement. Where things are less clear is when they invest in a bad business and then ask for only share repurchases. I have seen numerous iterations of this in the auto industry. Over the last 20 years activist investors have pushed automakers to buy back their stock when the cycle was running hot and these companies were making good profits. The trouble with that is, of course, that they run short of money when the cycle turns down. Would GM and Chrysler have had to file Chapter 11 in 2009 if they had stored up their cash in the 1990s and 2000s?
We’ll close out with one reason that never seems to work when it comes to buying “Bad” companies: valuation. At first blush, it would seem that simply buying a poor performer for a steep discount to its peers should give enough room for error that more often than not you’ll get a decent return. Yet without some catalyst, such as the ones we’ve listed here, it is too easy to end up in a value trap. No – bad company/sector investing requires more than simple valuation math to generate reasonable returns. It needs a roadmap, which itself is a good reminder of the “Good company/bad investment” conundrum. Rand-McNally, famous maker of maps and atlases, was sold in a prepackaged bankruptcy deal in 2003 after taking on too much debt as part of an LBO and then falling behind to more tech-savvy competitors.
You really have to keep your eyes on the road…
Originally posted on Convergex.com
