This "Risky" Stock Isn't That Risky

Higher risk doesn't always mean higher reward.

Sometimes risk is just risk.

For example, buying the shares of Motors Liquidation -- aka, the worthless "Old GM" stock that's still stubbornly trading after the recent IPO of "New GM" -- is the investing equivalent of jumping out of an airplane sans parachute.

Risky? Yes. Any real possibility of a reward? Not in this lifetime.

No, the real money is in stocks the market fears, but shouldn't. I've found a company that fits this bill perfectly.

Why the market's wrong
Seth Klarman is a master investor who has put up Buffett-like 19% annual returns since 1983. His wisdom is so cherished that his book on investing sells for $650 (used!!) on Amazon.com.

Regarding risk, he makes two points that every investor should understand:

  1. My earlier point that higher risk doesn't necessarily mean higher returns.
  2. Volatility doesn't equal risk.

Because of a fear of losses, most investors equate a jumpy stock price with risk. That's not the case. The risk lies with the inherent risks of the company not being able to pump out cash in the future and with overpaying for the company's stock in the first place -- not with the volatility of the stock price. All a volatile stock price does is offer you a chance to buy in cheaply. And if you can master this concept while other investors repeatedly make the mistake of fearing volatile stocks without investigating further, the returns can be tremendous.

Here's where I prove it
To illustrate my point, I looked for stocks with high stock price volatility over the past five years and positive free cash flow in each of those years . In other words, the investing equivalent of a virgin with a bad reputation.

Before I tell you about the gems I unearthed, I have to admit that many of the companies I ran across are both volatile and risky despite the positive cash flows.

  • American Capital (Nasdaq: ACAS  ) has been well over twice as volatile as the market (as measured by five-year beta). Since 2007, it's seen its stock price rise to almost $50 and fall nearly to $0.50. American Capital has been restructuring and paying down its debt, reducing its debt load by $3 billion since the second quarter of 2007. But this business development company still lumbers under enough debt to be scary given the market conditions.
  • Quantum (NYSE: QTM  ) takes it up a notch to be more than three times as volatile as the market. Its shares have had a bumpy ride because it has had spotty earnings power, it competes in the highly competitive and highly obsolete-able data storage industry, and because of buyout hopes that have ramped shares higher.
  • Commodities plays including AK Steel (NYSE: AKS  ) , Freeport McMoRan (NYSE: FCX  ) , Mesabi Trust (NYSE: MSB  ) , and Southern Copper have seen their positive cash flows valued wildly differently based on the price volatility of the commodities they rely on. The ongoing risk is that commodities prices will always fluctuate. Generally violently.

I'm not saying that these companies are bad investments. I'm merely pointing out that these stocks entail real risks that you have to weigh against the price you're paying. Read on. I'm seeing a better risk-reward opportunity out there.

Here's a stock to compare against
Tempur-Pedic
(NYSE: TPX  ) also makes this list. It's a good example of the market overestimating risk and offering up a tremendous buy opportunity.

In the past five years, it's gone from the mid-$30s at its 2007 highs, down to a low of $3.84 in March 2009, and now back up to the mid-$30s today.

Here's the funny thing. At no point during that period did Tempur-Pedic post a loss! Not one quarter. And its only quarter of negative cash flow came in the fourth quarter of 2007, more than a year before it hit its stock price low.

Tempur-Pedic was a proven winner that had a real risk: It was a premium mattress maker with a large debt load in a down economy. But the market drastically overestimated that risk given Tempur-Pedic's strong cash flows from operations. Investors brave enough to spot that mismatch could have generated close to a 10 times return on their investments.

It's no longer a screaming bargain today. It's far closer to a fair price than it was, but the market is currently overestimating the risk in another company that has had high volatility and positive cash flows the past five years.  

The opportunity
The company I found is even less sexy than a mattress maker, but I think you'll be as intrigued as I am. It's Gannett (NYSE: GCI  ) . Beyond owning 82 newspapers including USA TODAY, it has a digital division that has a large stake in CareerBuilder, and a broadcasting division that owns a bunch of television stations.

The market is fearing the risk inherent in Gannett's newspaper business. I agree that this business is a dying one, and I agree that there's a reasonably large amount of debt on the balance sheet, but I'm still getting excited about the stock as I write this.

Why? All three of Gannett's divisions -- including newspapers -- are profitable operationally. And in total, they're throwing off a killer amount of cash. How much cash? Its price-to-free-cash-flow ratio is just 3.6!

Yeah, you read that correctly. That's a ridiculously low figure. The real risk is not the dying newspaper business but that Gannett does something stupid with its cash flows instead of paying down its debt and returning cash to shareholders. Fortunately, that doesn't seem to be the case. Management has been consistently lowering its debt load, has been frugal about capital expenditures, and is paying out a small but promising 1.2% dividend yield.

The market thinks Gannett is dangerously risky -- just as it did with Tempur-Pedic a year and a half ago. I think the market's wrong again. That gives us a fantastic buy-in price. I will seriously be looking into buying Gannett.

I'm not the only one seeing a "risky" stock that isn't. The Motley Fool has put together a free report detailing the "risky" stock Warren Buffett is secretly buying. In addition to checking out Gannett for yourself, click here for free access to the report.

Anand Chokkavelu owns shares of Tempur-Pedic. No, he didn't buy in at $3.84. He averaged into the stock in the teens before the financial crisis and then sold half his position in the $30s post-recovery. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (17) | Recommend This Article (40)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 01, 2010, at 10:55 AM, pondee619 wrote:

    "Its price-to-free-cash-flow ratio is just 3.6!"

    What is the industry average?

  • Report this Comment On December 01, 2010, at 11:16 AM, TMFBomb wrote:

    @pondee619,

    Good question. Looking at P/EBIT as a quick proxy, Gannett's is 5.4. Its 10 close comparables average 10.8.

    -Anand

  • Report this Comment On December 01, 2010, at 1:52 PM, factoids wrote:

    Debt debt load of ACAS is not the problem. While the debt per share to NAV per share is high, there are several other BDCs with higher ratios [MCGC and TCAP] and some that are close [KCAP, MAIN and PNNT].

    What appears to make ACAS volatile is the high level of non-accrual loans on the books. When the market is optimistic, it prices ACAS as if all those loans will be made right again. On the days the market is pessimistic, it prices ACAS as if all those loans should be worth nothing.

    And this is not an ACAS only phenomena. You find the same pricing action with banks and other financial stocks that also have high non-accrual or non-performing assets.

    Why has ACAS been rising this year? It's NAV/share has stopped falling - while at the same time is began the year selling at 31% of its NAV.

  • Report this Comment On December 01, 2010, at 2:27 PM, Farris76 wrote:

    Ok, let's talk about NAV. on ACAS

    First... NAV. is both understated and overstated.

    How is that posible.

    Well European capital is currently undervalued in ACAS's NAV. as in the NAV of European Cap is sub par by quite a bit.

    This is discounted by the liklyhood of recovery of the NAV in Europiann Cap. However if you look at the NAV to trade price the compleate NAV of Eurocap is discounted off.

    This makes ACAS an atractive stock for upward motion assuming recovery of Eurozone.

    Also the American diversified investemnts seem to be performing adiquately to expunge debt off the b-sheet on time if not early.

  • Report this Comment On December 01, 2010, at 6:03 PM, grant224 wrote:

    Anand,

    Although the company is profitable, I notice revenue as well as cash from operating activities seem to be decreasing consistently. Net Income seems to be on a similar slide and although GCI has additional business ventures beyond paper, I wonder if they are simply not potent enough to match past numbers.

    Although I was originally intrigued, (still am) these declines seem to fit in with the current, "newspapers are dying" mentality and I assume it is part of the reason why the market has priced it the way it has.

    The market is not very smart however, so I wonder if you could go into more detail (beyond the label, "operationally profitable") regarding whether or not the company is actually increasing profitability, or if it is simply "still" profitable.

    To put it another way, my main concern is whether or not GCI is actually swimming forward or if they are just staying afloat.

    From your article it sounds as if they are indeed floating, but on a very comfortable raft, that will be around for awhile.

    I would appreciate hearing your thoughts, and thanks for the article,

    Grant

    Btw,

    As a reader, I wish you would have spent more time analyzing Gannett and less on the stuff above your analysis. Just an opinion..

  • Report this Comment On December 01, 2010, at 11:25 PM, jlanganki wrote:

    News Corp is a much smarter company: they actually charge for content! USA Today is a worthless newspaper. P/CF is a useless metric for a company with this much debt. You should at minimum be using EV/CF. You should also look at their declining revenue and figure out if the company is even solvent (will their cash flow drop to zero before they pay down their debt?) Sure, they will probably survive for a number of years, but this is by no means a "safe buy" at this price.

  • Report this Comment On December 01, 2010, at 11:27 PM, jlanganki wrote:

    I'd try the dart board method before buying this stock. Just an idea.

  • Report this Comment On December 02, 2010, at 8:29 AM, TMFBomb wrote:

    @grant224 and jlanganki,

    My point isn't that Gannett is a world-beater...just that the market is mispricing it. In other words, I believe the current price is underestimating Gannett's remaining cash flow capability.

    Fool on,

    Anand

  • Report this Comment On December 02, 2010, at 11:36 AM, pondee619 wrote:

    Anand:

    I asked: ""Its price-to-free-cash-flow ratio is just 3.6!"

    What is the industry average?"

    You answered: "Good question. Looking at P/EBIT as a quick proxy, Gannett's is 5.4. Its 10 close comparables average 10.8."

    However, CAPS Ratios shows:

    http://caps.fool.com/Ticker/GCI/Ratios.aspx

    Price to Cash Flow (TTM) GCI 4.10 Industry 4.40

    Price to Free Cash Flow (TTM) GCI 4.00 Industry 4.90

    Why are we looking at a "quick proxy" when CAPS has the true stats cited? Is the difference of 4 to 4.9 that great?

  • Report this Comment On December 03, 2010, at 1:05 PM, TMFBomb wrote:

    pondee619,

    I used the proxy b/c I was using my original data provider Capital IQ, and it was handier. I'm not sure how the industry is defined in CAPS (CapIQ was using 10 close competitors), but it's a fair point that most newspaper-driven companies have low multiples.

    Three points:

    1) It's possible for there to be more than one value in an industry.

    2) Gannett is more than just newspapers (though that's the biggest part).

    3) I like what I've seen from Gannett specifically.

    Fool on,

    Anand

  • Report this Comment On December 03, 2010, at 2:54 PM, pondee619 wrote:

    Anand:

    Since I asked a good question, don't I deserve a good answer?

    You say you used a proxy because it was "handier".. That is BS. Take the time, refer to your research and answer the question based upon the metics you introduced. Hasn't the passage of time allowed you to go back to your orginal research and see how the price-to-free-cash-flow ratio of GCI compares to its industry, however you define it? How can you state that "That's a ridiculously low figure" without knowing how it compares to others in the business? You do not get a pass saying that a good question was asked. An answer is expected. Maybe not from fool writers, however. You don't know how this metric of GCI compares to others in its industry, do you? You are just blowing smoke when you state "That's a ridiculously low figure" because you have nothing to compare it to. Upon what are you basing your "articles"? Guesses?

  • Report this Comment On December 04, 2010, at 11:28 AM, whyaduck1128 wrote:

    I worked for a major division of GCI back in the mid-1980s. One thing I learned is to never trust the published numbers. When I got back into the market, I invested in all of my other previous corporate employers--but not GCI.

    I'm not saying anything is wrong with their numbers, only that to this day I don't trust them.

  • Report this Comment On December 05, 2010, at 12:37 PM, kwl1763 wrote:

    Comparing GCI to temper is ridicuolous. While I don't disagree GCI may be a value there is a huge risk that you claim is not there. There is a very good chance the're whole industry just dies. Sure they are converting some to digital but there are tons of companies better at this then they are. The whole industry is dying and being reinvented online and few are doing so profitably. Pretty big risk I would say. Temper's is a pure competitive risk (which GCI certianly has onlne in addition to the industry rich). Certainly beds aren't going away anytime soon. Now I don't like TPX here as I think it's fairly valued at a minimum but saying GCI is less risky is crazy! The key to valuation is projecting CF out not looking at a static x times CF today or even next year. I feel much more confident attempting to forecast TPX vs. most of GCI's business 9TV probably being the only exception. That is a good indication of risk right there.

  • Report this Comment On December 06, 2010, at 5:14 PM, TMFBomb wrote:

    @pondee619,

    Using Capital IQ's definitions, Gannett's P/FCF is 5.45 vs. its comparables' average of 7.10.

    -Anand

  • Report this Comment On December 07, 2010, at 3:00 PM, pondee619 wrote:

    So, which set of "numbers" is correct? CAPS says one thing; "Price to Free Cash Flow (TTM) GCI 4.00 Industry 4.90 " , Capital IQ says something else; "Gannett's P/FCF is 5.45 vs. its comparables' average of 7.10.". One thing is certain, no one agrees with anyone else on anything. Not one number matches what the other says.

    Why didn't you have this comparision at your finger tips immediately after writing a "story" extoling how good GCI's number was? How could you tell that GCI's number was so good without knowing what the industry average was?

    Why did it take you 4/5 days to finally find figures that supported your thesis?

  • Report this Comment On December 08, 2010, at 1:07 AM, dragonLZ wrote:

    Anand, I guess we agree on this one (just when I thought we can't agree on anything, first comes BAC, now GCI. This is getting kinda scary, don't you think? :) )

    Last time I updated my Volume Story (in this post here: http://caps.fool.com/Blogs/are-you-kidding-me-hecla/482249 ), GCI was at +54% return since Sept. of 2009, today, only four days later, at +64%.

    So don't feel too bad if people think you are wrong on this call. So far, GCI is proving the sceptics wrong.

    FWIW, I also re-picked GCI as outperform for my CAPS portfolio around the same price you made your "not so risky call."

    http://caps.fool.com/Pitch/GCI/5221452/gannett-co-inc-gci-is...

    Good Luck!

  • Report this Comment On December 10, 2010, at 8:49 AM, TMFBomb wrote:

    @dragonLZ,

    Haha, glad we have a second stock to share!

    Fool on,

    Anand

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