TCS Daily

Blue Light Specials

By James K. Glassman - January 29, 2002 12:00 AM

Originally published in The Washington Post

Looking for a bargain? A surprising number of readers in recent days have excitedly asked me about two stocks they want to buy because they look so cheap. One is Enron; the other is Kmart.

Both are in bankruptcy. Enron, focus of various criminal investigations, was booted off the New York Stock Exchange, but it was trading over-the-counter last week at 37 cents a share. Kmart, the venerable discount chain that has had the misfortune to compete against the greatest retailer of all time, Wal-Mart Stores, closed Friday at 85 cents.

To folks who want to invest in stocks like these, I have three things to say:

  • Don't do it.

  • Still, hearty congratulations for having the right instincts.

  • Now, listen to a better idea along the same lines.

  • First, though, why shouldn't you buy a firm like Kmart, America's No. 2 discount retailer, with 2,100 stores and $37 billion in revenue? Its market capitalization -- that is, the total value that investors put on all of its outstanding stock, is a mere $463 million -- or about five days' sales. And don't investors go overboard on bad news, driving stock prices to ridiculously low levels in their haste to bail out? In short, isn't Kmart just the kind of company that value-lovers should adore?

    Attention, Kmart shoppers: The first problem with this stock is that no one can possibly say what it's worth. Some of the stores and inventory will be sold off; the brand may survive; the business focus may change. Who knows? And, frankly, who cares?

    The only good reason to invest in a stock is not that the company's salvage value may be somewhat higher than the market believes, but that the company itself is strong, profitable, well-protected against competitors, and likely to thrive for many decades. This, no one would say about Kmart. Or Enron, for that matter.

    And remember that a stock trading for 67 cents can go to 2 cents, and you are just as badly burned as if a stock trading for $67 went to $2. Still, there are many fine companies that, because of temporary setbacks, have suffered huge stock declines. If you want to go bottom-fishing, those stocks should be your piscatorial prey.

    Yes, a firm whose stock has dropped sharply is often a firm that is in serious trouble, but many times the panicky overreaction of shareholders to bad news creates exceptional buying opportunities -- especially if the firm has strong management and a light debt burden.

    How well can losers do? Here's a remarkable example:

    The investing firm offers 110 "ready-to-go Folios" -- that is, diversified portfolios of bonds or stocks, each with a theme, such as Mid-Cap Growth (medium-size companies that are increasing their profits quickly) and Minority Leaders (companies with the most minority members on their boards). Far and away the best-performing Folio right now is called Worst of 1999 -- a portfolio of the 30 stocks that declined the most in that year.

    From its inception on April 6, 2000 -- the date that itself got started -- through Dec. 31, 2001, these stocks have returned an amazing average of 45 percent, compared with a loss of 22 percent for the benchmark Standard & Poor's 500-stock index. Over the past 12 months, the Worst of 1999 portfolio has beaten the market by 87 percentage points! By contrast, a folio comprising the best-performing stocks of 1999 has declined 51 percent since its inception.

    Simply betting on big losers, however, is not a brilliant strategy. Investing isn't that easy. Some stocks take a punch and never get up from the canvas again. But it makes good sense to use a list of losers as the starting point for finding good companies to buy and hold for the long term. Just remember that each loser has its own story. Here are some from the list of 1999 worsts:

    ý General Cable Corp., which makes copper and aluminum wire and fiber-optic conduits for communications, energy and electrical markets, fell from $20.50 to $7.56 in 1999 and then kept dropping -- to a low of $4.20 late in 2000. While the company was shaky and debt-heavy, it managed to reorganize by selling off many of its foreign subsidiaries. It's now trading at $13.53, with earnings projected at about 70 cents a share for 2002, for a price-to-earnings (P/E) ratio of about 20.

    General Cable's diversification has kept it from completely tanking, the way many other fiber-optic specialists have. Still, this is a firm exposed to the strong winds of competition in a business where brand names don't mean much. It may still be cheap, but it probably should not be an addition to your portfolio.

    ý Henry Schein Inc., which is a wonderful company and one of the great success stories in the group. It's a distributor of health-care products to medical doctors, veterinarians and dentists. The stock fell from $44.75 to $13.31 in 1999, mainly because profits didn't rise as much as expected and sales growth began to slow. But the next year the stock nearly tripled, shooting back up to $34.63. It currently trades at $43.17 and is rated "1" (among the top 100 of all stocks) by the Value Line Investment Survey.

    Schein is a solid company, with little debt, in an excellent business. Since it went public in 1995, it's increased profits every year at an annual rate of better than 20 percent. It currently trades at a P/E of 25, which is not too expensive for such a fast-growing company. You could have bought it for a P/E of just 11 in 2000, though. Schein is the kind of company you can ask your own doctor or dentist about, but it looks like a keeper.

    ý Waste Management Inc., the largest solid-waste disposal company in North America, with sales of $11 billion last year, suddenly lost three-quarters of its stock value in 1999 after an unproductive merger. The sharp decline was a sign something was terribly wrong and, indeed, earnings plummeted the next year. Since then the company has restructured, selling nearly all its non-U.S. operations, and the stock has recovered from $14 to about $30 -- but that's still far from the 1999 high of $60. Waste Management is heavily burdened with debt and, despite its powerful position in a sector that can only grow, does not appear to be the kind of company most investors will want to own for the long term.

    What about more recent losers? The Worst of 2000 Folio managed a loss of just 2 percent in 2001, beating the S&P by about nine percentage points. But unlike the 1999 list, which was well-balanced, this one is overwhelmingly high-tech, with stocks like Lucent Technologies, RealNetworks, Novell and Xerox. Also, a single year tells you little about any portfolio. Give it some time.

    The 2000 list, however, amply demonstrates that what goes down can keep going down. InfoSpace Inc., for example, hit a high of $138.50 a share that year and finished at just $5.40. Did it bounce back? Nope. Currently, the Internet-infrastructure company trades at 2.26. Similarly, Sapient Corp., an e-services consulting firm, fell from $74.50 to $8.90 in 2000 and now trades at $5.23.

    The point, however, is not to judge a stock by its price movement but rather by the likely success of the underlying company. Consider Yahoo Inc., the world's most-visited Internet site (132 million consumers in the latest month). It fell 90 percent in 2000 and earned a place in the Worst Folio. In 2001 it fell by another50 percent. But in the high-tech, high-risk portion of your portfolio (a tiny portion, let's hope), Yahoo may deserve a place. Value Line expects Yahoo to earn $70 million next year on revenue of $820 million. Within five years, analysts predict, the company will see profits of about $1 a share for a stock recently trading around $18.50 -- though such projections are notoriously inaccurate. Yahoo has no debt and about $1 billion in cash.

    While some stocks fall and never come back, others stage magnificent long-term rallies -- often as the result of a change of management or strategy. International Business Machines Corp. is a good example. Between 1991 and 1993, its stock fell by 70 percent, but since then it has risen by a factor of 12, not including dividends.

    Your job is to find stocks that will make similar comebacks. Candidates abound, in nearly every sector. Hewlett-Packard? Campbell Soup? Cisco Systems? Newell Rubbermaid? Companies like these -- firms with strong track records that have fallen on bad times -- present far, far better opportunities for long-term profit than Kmart or Enron, even at less than a buck a share.

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