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Fool On The Hill

Friday, January 29, 1999

FOOL ON THE HILL
An Investment Opinion
by Warren Gump

Digging for Value

As those of you who read my columns know, I am a value kind of guy. Give me a company that has the possibility of growth or turnaround, an attractive industry, a reasonable multiple, and my little stock-lovin' heart palpitates. Rewards from this kind of investing are not immediate. Stocks that are "out of favor" or haven't caught the attention of investors often stay that way for quite a while. In addition, companies that run into trouble often continue to have problems for a while. But over time, these kinds of stocks often provide sweet returns.

There are some companies out there almost everybody would like to have in their portfolio. If they aren't a part of one's holdings, the reason for exclusion (beyond the fact that very few of us have enough money to buy everything we want) is generally valuation. I would love to be an investor in Dell (Nasdaq: DELL), America Online (NYSE: AOL), Microsoft (Nasdaq: MSFT), or Gillette (NYSE: G). Heck, I'll even add Coca-Cola (NYSE: KO) to the list, overlooking my strong personal preference for PepsiCo (NYSE: PEP) products, because of its wonderful business model and so many other folks' peculiar preference for Coke products.

Given my investment style, however, I am not in any of the above mentioned stocks (excluding Pepsi). The analytical side of me just won't let me pull the trigger. Over the past few years, staying out of these stocks has been a mistake, as they have provided superb returns. Heeding David and Tom Gardner's advice that valuation doesn't matter when dealing with Rule Breakers and Rule Makers would have allowed me to enjoy terrific gains over the past decade. Nonetheless, I'm a stubborn old Fool and unwilling to put my money down if I can't intellectually rationalize a valuation.

Why do I have a preference for the value style? Historically speaking, a value investing style investing in low P/E stocks has tended to provide higher returns than investing in higher P/E stocks. According to a study published in Contrarian Investment Strategies: The Next Generation, a book by value maven David Dreman, buying the lowest quintile stocks based on P/E ratios significantly outperformed buying higher P/E quintiles between 1970-1996. The lowest P/E quintile among the largest 1,500 companies in the Compustat database returned 19.0% annually throughout this period, compared to 12.3% annual returns for the highest P/E quintile. (It also beat all of the other P/E quintiles by a large margin; the market returned 15.3% during the same period.)

Then again, a preference for value is ingrained in all my personal style. When shopping for clothes, I get much more excited about finding an out of season Abercrombie & Fitch (NYSE: ANF) flannel shirt on sale for $19.95, than the hot new spring design that is selling for $69.50. Being patient and waiting three months often provides me the opportunity to find the formerly hot shirt marked down to $19.95 as well. Sure, I might not be able to use it for six months after I buy it, but the shirt will still provide many years of pleasurable use.

High quality stocks are not like outerwear that goes in and out of style on a seasonal basis. Under no regular pattern, however, these stocks do move around. Certainly we saw what ended up being a fire sale on many stocks in early October. Many people were envisioning Armageddon. Savvy folks, who knew what stocks they wanted to own for the long term, were able to pick up some of their "wish stocks" at what seemed like reasonable prices. (Of course, they had to be willing to step up to the plate while other batters were running for the showers.) At other times, great companies are knocked down for a reason, with earnings warnings being the most common one.

On Tuesday, one of the unsung darling stocks of the decade, Service Corp. International (NYSE: SRV), shocked analysts when it announced that its Q4 earnings per share (EPS) could fall as much as 39% below the prior year and 48% below expectations. Service Corp. is the world's largest funeral and cemetery company. It has achieved rapid growth by consolidating smaller players in the industry. At September 30, 1998, the company operated 3,370 funeral service locations, 430 cemeteries, and 180 crematoria located in 18 countries on five continents.

This earnings announcement meant that 1998 earnings would be essentially flat with 1997's results, a shocking event for this consistent grower. Even worse, the company cautioned that given current trends, 1999's results could be flat again. Excuses for the problems were aplenty, including reduced mortality in key markets, higher operating costs, lower than expected cemetery revenues, and disappointing results in foreign markets.

Run for the door, baby! Despite the fact that this company has steadily increased EPS from $0.58 in 1993 to $1.31 last year, everyone simultaneously hit the exits. (I believe the company's earnings growth had been much longer than the past five years, but I can't readily get my hands on the supporting data.) The 44% one-day drive took the stock price back 3 1/2 years in time. Not quite six feet under, but getting close. At the current price of $15 15/16, the company is trading around 12x company earnings guidance for 1998 (and 1999, for that matter).

Service Corp. obviously has numerous problems. A significant shortfall like the one announced, thrown suddenly on investors after years of extremely consistent performance, indicates there are some serious issues the company is facing. The problems are obviously real and will probably not be resolved for at least a year or two. One of the biggest problems is the uncertainty of not knowing exactly what went wrong. Can the company rebound? Is its long history of strong growth over forever?

The same questions are often asked of other stocks when they are beaten down. In late 1997, investors were concerned that Oracle (Nasdaq: ORCL) was down for the count. Despite its market leading position, analysts were concerned the database market had slowed down. Competition was increasing. The stock was knocked down from $40 1/16 to $17 3/4 over a four-month period. A little over a year later, the stock has rebounded to over $54 as the company regained its footing. Other fallen stars have recovered more quickly, while many take much longer. Some never regain their luster.

Investing in a stock just because it has fallen significantly is foolhardy (note the very intentional small f). If you're willing to dig around a bit and understand the company more, however, you could find some gold lurking in the demised. I haven't had enough time to sit down to totally figure out Service Corp.'s business (it's somewhat complicated, combining its core business and financing operations). Maybe it's on its deathbed. Then again, are people going to stop dying? (If your answer is yes, would you tell me which drug or biotech stock to buy?)

One thing is certain. Over the next six months, I'm going to invest the time to get to know the deathcare business and Service Corp. International much better.

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