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:
- My earlier point that higher risk doesn't necessarily mean higher returns.
- 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 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.