Even the best companies, industries, and sectors fall out of favor from time to time. A fully-informed investor, with a pocket full of cash and a firm understanding of the situation, can calmly stride into a turbulent market and acquire shares of these underdogs at a fraction of their intrinsic value. How do you know which companies are permanent losers and which are undervalued gems? Answering the following questions and tests of quality will help you determine if you should invest your money or keep it stashed in cash.
1. Is The Problem Temporary or Long-Term?You must be careful not to simply invest in a company because everyone else is running from it; sometimes there is a reason to run! There are many companies that aren't worth buying at any price. Trash is trash, regardless of how much you pay for it.
In some cases, problems arise that are the result of one-time mistakes on the part of management. During the Savings and Loan crisis, for example, bank stocks were beaten down to almost comical levels. An investor who mentioned he was purchasing shares of these institutions was immediately scorned, mocked, and considered crazy by even close friends. At the same time, firmly entrenched companies such as Wells Fargo (which boasted a solid balance sheet, established reputation, top-notch management, and steady customer base), were hit just as hard as banks of lesser quality.
Years later, those that had exercised courage and relied on their analytical judgment by purchasing shares in such banks found their portfolios much fatter. Remember the words of a very wise man; "you are neither right nor wrong because the crowd agrees with you; you are right because your analysis says so."
2. Is the Business an Excellent Company with Suitable Market Capitalization?As always, you should be interested in non-asset intensive businesses with high returns on equity, little or no debt, operating in non-commodity type industries without fixed cost structures. You should also attempt to look for undervaluation in larger companies rather than smaller ones. In the event of a retail recovery, for example, Wal-Mart is more likely to get back on its feet sooner than a small specialty retailer such as Tuesday Morning. The owner of smaller issues may find himself waiting considerably longer for his shares to realize their full value in the market.
3. Does Management Have an Excellent Track Record?Great management tends to produce great results for everyone involved, including the shareholders, employees, directors, executives, and customers. If a company has encountered significant problems for consecutive years while the industry in which it operates prospers, it is likely that management has been unwisely retained. In such cases, you and your pocketbook would be better off ignoring the empty promises of executives who are only interested in keeping their jobs.
The quality of management question is perhaps one of the most important an investor must pose to him or herself. Coca-Cola is an excellent example of how good management can make a great company even better. A stellar performer for generations, it wasn't until Roberto Goizueta became CEO that the business became a truly global powerhouse, throwing off cash to its stockholders faster than they could gulp it down. Between 1984 and 1993, Coca-Cola acquired 570 million shares of its own stock through its stock repurchase program, reducing the shares outstanding from 3.174 billion to 2.604 billion.
This 21% reduction resulted in significantly higher earnings-per-share for each of the remaining shares of common stock, bolstering already mouth-watering operating results.
With that said, it is important to keep in mind that past results do not guarantee future performance.
4. Are You Financially Able to Wait Out the Storm?After you've determined that the company's problem is temporary, management has an excellent track record, and the business possesses excellent economics, there is still one question remaining before you consider purchasing a seemingly undervalued stock. Are you financially able to wait out the company's troubles? What are the odds that you will be forced to sell your stock to meet another obligation?
If there is even the slightest chance of a forced sale due to a personal need for cash, don't even think about buying the stock. "But it's a wonderful investment opportunity!" you may protest. Yes, it may turn out to be one of the best investments of your life. However, if you do not have the luxury of waiting for the company's intrinsic value to be reflected in the share price, you are gambling. As investors, we know that a good company will eventually be recognized by the market; we don't know when.
The moment you fail to make that distinction, you become a speculator. In the short run, anything can happen. There is nothing to stop an undervalued stock from falling significantly further in price. You must have the time to wait for the inevitable result of wise investing, regardless of whether it takes a week, month, or several years. In the end, your sound analytical judgment and unshakable patience should be handsomely rewarded.