TCS Daily


Nothing's Arbitrary About the Contrarians

By James K. Glassman - July 2, 2001 12:00 AM

History's greatest investors have found lots of different ways to get rich. Warren Buffett likes to become a partner in a great business with a huge and loyal customer base. He's long been a fan of dominant local newspapers, for example. Benjamin Graham, Buffett's mentor, used to ignore what businesses actually did, so he could take an unbiased look at the financials. Philip Fisher's approach was to hit the road and visit companies to take the full measure of management mettle. (Each one is profiled in John Train's excellent book, Money Masters of Our Time.)

Yet all successful investors have, by definition, had one thing in common - they all found a way to identify value before it was recognized by the broader market. To put it another way, all great investors are contrarians. They invest in companies that the market has given up on, or has never really appreciated. Obviously, nobody got rich buying Cisco when the whole world thought it would increase earnings by 50 percent every year. But those who bought Cisco back when most investors still thought it was some kind of food distributor made enormous gains.

The biggest opportunities often arise when a giant has stumbled. After a huge corporation runs into trouble, investors often flee without appreciating how much staying power a major multinational can have. This does not mean that every company whose stock declines is cheap and destined to rebound. Prices can always go lower, and some companies keep stumbling all the way out of business. But markets often overreact to bad news, just as they do to good news.

In fact, buying on bad news can be highly lucrative. The "Dogs of the Dow" strategy, variations of which involve buying the highest-yielding Dow stocks or the firms with the lowest price/earnings ratios in the index, has generated excellent returns. If a company is paying a high dividend, relative to its price, that means that investors don't have much faith in the company. Basically, the company has to pay them a lot of money each year to hold on to the stock. On the other hand, investors don't demand a nickel of dividends from Microsoft, because they believe that by reinvesting their money today in new products, Bill Gates will create even more wealth for them in the long term.

Similarly, a low price/earnings, or P/E ratio, says that investors don't think the company has a very bright future, because they're not willing to pay much for each dollar of earnings. And when other investors think a company is headed for trouble, that often spells opportunity. For the true contrarians in the tech world, Smartmoney.com, an excellent personal finance website, recently set out to identify the unpopular but potentially rewarding companies in techland.

"We decided to look for the stocks investors most hate at the moment. The stocks they scorn. The ones they despise," reports Smartmoney's Cintra Scott. "We tuned our search engines to find companies that are both beaten down and promising." That means companies scorned by investors, inexpensive relative to their current earnings, but with histories of strong growth, modest debt, and good prospects for the long term.

You might consider a number of the market pariahs on Smartmoney's list. Corning (GLW) makes the glass fibers in fiber-optic telecommunications networks. After falling from a 52-week high of $113, the stock has been bouncing around in the $13-$15 range. The telecom sector has been beaten up lately, but this is a world-class supplier of critical components and most analysts see strong worldwide growth in this market over the long term.

Another firm with lots of telecom clients is Dycom Industries (DY), which handles the construction of new networks. At a P/E ratio of about 13, Dycom already has a lot of bad news built into the price of its shares. It's fallen from $56 down to $22. Any good news in the telecom industry could spark a rally.

Tellabs (TLAB) makes telecommunications hardware for the latest digital networks, and its stock has fallen more than 60 percent from its high. With a P/E around 9, TLAB also looks attractive to those with a contrarian streak.

If the economy rallies soon - and that's not an unlikely prospect - current prices could look awfully anachronistic. Sure, there are no guarantees; there never are for contrarian investors, but that's why they make so much money when they're right.
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