A short time back, the inhabitants of Gems World and I set out to lay bare the secrets of Hidden Gems investing. Our mission: to get inside the head of Tom Gardner -- or, less invasively, to determine just how his small-cap wonders manage to spend more time in the winner's circle than Smarty Jones.
But is it art?
It was a short, strange trip that led us from insider ownership and the beauty of return on equity (ROE), past true profitability, all the way to focus, focus, focus. It's one I'd recommend you take yourself, if only vicariously through the handy small-cap primer that was its unexpected result. (Chapters retrievable most conveniently at Hidden Gems Central: Access All Areas with a free trial.)
Yet, for all we've learned, what strikes me most about the exercise and the criteria laid out these past few weeks is what slipped through the cracks. I just can't shake the feeling that there's a certain essence that our little algorithm -- or for that matter, any method or model or series of rules -- fails to capture. Let's call it art, then -- the art of picking great stocks.
Bear to look
Of all the pearls of wisdom bandied about Fool HQ -- far too many of which I suspect one or the other of us has botched or made up entirely -- one of my favorites comes by way of Tom Gardner and goes something like this: "Look for stocks where other investors are afraid to." Whoever said it first, I love it. Among other things, this distilled contrarian philosophy confirms that picking stocks is more than mathematics.
Yes, a deep-value stock screen might tell you where investors fear to tread. But that kind of black-box investing strikes me as risky and scary business. I'm all about spotting value, but herein I think lies an entirely different challenge. Namely, that we strive to "see" what others don't -- to recognize the power and beauty of a business, not just ahead of the mob but sometimes before any of it even turns up in the numbers.
Fired for buying IBM?
My first experience with this must have been, of all things, IBM (NYSE: IBM) after Lou Gerstner took the helm back in 1993. For all the world, the company looked dead in the water and on the verge of breaking up, but Gerstner would have none of it and put his money where his mouth was, buying a chunk of stock himself. More importantly, he slashed costs, sold off unprofitable operations, and instituted a new corporate culture.
In other words, IBM in the mid-1990s was a classic, new management turnaround -- one that, from a $5 billion loss in 1992, was understandably slow to cross institutional radars. A more recent example might be last year's McDonald's (NYSE: MCD). And this year? On a much smaller scale, both are reminiscent of the situation at funeral service provider and Hidden Gems recommendation Alderwoods (Nasdaq: AWGI). I'll explain.
Forget for a moment that Alderwoods operates in an especially unsavory niche (though no less than Peter Lynch is attracted to just such businesses). In the late '90s, the company (then Loewen Group), bloated and burdened by debt, was forced into bankruptcy, only to emerge in January 2002. Today, under turnaround management, the new Alderwoods generates cash, is paying down debt, is growing earnings, and stands out as a best-practice provider in an admittedly checkered industry. Finding this one, which has been a standout for our members, was more art than science.
Just hear me out
Let's face it, when you buy a gem that's not only hidden but, to some investors, downright morbid, you're going to bend a few rules. Ideally, you'd like to see less debt and a higher ROE. Personally, I'd like to see a few more shares in the hands of top executives at Alderwoods. However, the key here, as it so often is with turnarounds, is that new management has turned the business around and the market has been (at least was) slow to recognize the value.
It's largely because of this peculiar market inefficiency that Alderwoods is not our only hidden gem that could be characterized as a turnaround. Toy maker Hasbro (NYSE: HAS) was one of the earliest Hidden Gems picks. Then there's an international fruit company that's a household name and a satellite equipment maker whose client roster boasts Viacom (NYSE: VIA), Disney (NYSE: DIS), and General Electric (NYSE: GE), among others.
As turnarounds, none quite lives up to our strictest ideals, but all are gems. As it turns out, for all our emphasis on rules, flexibility ultimately proves the key to successful investing. But be careful: As with all things, we have to learn the rules before we break them. And even then, not everything goes.
Bringing it back home
As an example from my own portfolio, I own (from my wild and crazy pre-Fool days) shares of Internet comeback kid InfoSpace (Nasdaq: INSP). I even bought some shortly after a reverse stock split -- a statistical sign of doom if ever there was one. Why not? The balance sheet is strong and business looks by all indications to be firmly back on track.
And, in fact, the stock has done remarkably well. But for all that, InfoSpace is not truly a hidden gem -- at least not yet. Too many questions remain about the sustainability of the business and management's focus, and that negative ROE is a tough hurdle. Point being that, for all my talk of art and the virtues of winging it, we must always distinguish between sound, long-term investments and speculations -- though, granted, much remains in the eye of the beholder.
If you're like me, this sense that we're no longer painting by numbers leaves you feeling not a little exposed as an investor. Perhaps that is why our Alderwoods discussion board is among the most active in our Hidden Gems online community, and why there's as much company knowledge on the board as at any house on Wall Street. Management is clearly doing the right things, but it's a comfort to know that we have eyes trained on its every move.
Of course, that idea is not entirely new. Institutional money managers very often work in teams and vet their picks before their peers. Who knew picking stocks was such a touchy-feely business?
For more on the philosophy of Hidden Gems and for the gems themselves, click here to take a free trial.
Paul Elliott corrals the Hidden Gems team and owns shares of InfoSpace. The Motley Fool has a disclosure policy.
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