In Beat the Street With Value, I made my case for value investing and promised to outline how I go about the search for the recommendations I provide in my Inside Value newsletter. Last week, in Hunting for Value: Part 1, we went in search of Wounded Elephants, Cyclicals, and Former Glamour Stocks. This week, we will be on a quest for Fallen Angels, Bankruptcy Survivors, and the elusive Stealth Stocks.
In my Fallen Angel category, you will find the companies that have been accused of fraud, have been targeted by SEC investigators, or are the subject of an Eliot Spitzer lawsuit. Two excellent examples from recent history that interested me enough to buy them were conglomerate Tyco (NYSE: TYC ) and specialty drug company Elan (NYSE: ELN ) . I bought both too soon on the way down but was able to buy more at lower prices. Both stocks have recovered to well above my initial purchase prices.
At Tyco, executives apparently were looting the company, and everyone was jumping ship. The stock slumped to $10 and change, but with new a new board, new management at the helm, and tremendous cash-producing assets, Tyco was a steal. Today, the stock price is around $34. Elan had even greater difficulties after the discovery of several off-balance sheet ventures and a restatement of financials. The company had to sell off several assets to stay afloat, but the remaining drug pipeline showed a lot of promise. In 2002, the shares went below $2. Even a year ago they could be had for just $5. The price today? Nearly $27 -- a proverbial Peter Lynch 10-bagger! The key here is to look for a change in management, an improving balance sheet, and strong free cash flow.
A stock on my watch list in this category is Marsh & McLennan (NYSE: MMC ) . It's under fire from New York Attorney General Eliot Spitzer, who is alleging the company rigged insurance bids in cahoots with large insurance companies. This is a serious charge, as Marsh is an insurance broker and as such is bound to find the best deal for its clients. It allegedly arranged higher noncompetitive bids from insurance companies, such as American International Group (NYSE: AIG ) , in return for lucrative payments. This ensured their clients actually got charged more for insurance, defeating the purpose of using a broker in the first place. For Marsh, this is compounded by mutual fund subsidiary Putnam's involvement in last year's mutual fund scandal.
When looking at companies like Marsh, I look for a change in top management because, as was pointed out by Fool contributor Rogene Calvet, there is a corporate culture issue, at least at the top executive levels. The former CEO, Jeffrey Greenberg, has resigned and has been replaced by Michael Cherkasky. Cherkasky is not tainted with either scandal as he was most recently CEO of Kroll Inc., which was acquired by Marsh in July of this year. In a strange twist, Cherkasky was Spitzer's boss in a previous position. Just last week the board announced that all management directors, save Cherkasky, have resigned.
What makes Marsh interesting to me is that its other business units are worth not much less than today's $27.70 per Marsh share. The trouble is that we do not yet know what financial penalties will be levied or the outcome of several class action lawsuits. Marsh is already reporting that some clients are splitting business that was formerly 100% Marsh, and then there is the loss of those lucrative payments, which have been estimated to be as high as one-third of Marsh's profits. However, it is still the largest insurance broker in the world and is likely to survive, especially as Spitzer has stated that he will not pursue criminal charges.
Investors are nearly always wary about investing in Bankruptcy Survivors. It stands to reason that psychologically, we don't want to get burned again. Let me just mention that I'm not advocating buying shares whilst a company is still in bankruptcy, but after it comes out with the slate wiped clean, new management, and fresh-start accounting. Not all are suitable investments, but a few well chosen can boost your portfolio returns. The key here is to look for good assets, great cash flow, and above all new management with a reputation for good cash management.
Right now, I have none on my watch list. However, I would happily recommend Tom Gardner's Hidden Gems pick Alderwoods Group (Nasdaq: AWGI ) , a leading provider of funeral services. The company emerged from bankruptcy in January 2002 under highly experienced new management, and in less than two years, the turnaround team has paid down more than $200 million in debt. I own this one and expect it to continue to do very well over the next two years.
At Inside Value, one of my first two picks was MCI Inc. MCI was formerly known as WorldCom, which was the biggest bankruptcy in world history and one of the worst examples of corporate avarice and fraud. MCI has new management and nearly as much cash as debt, and it produces a ton of cash flow each quarter. May be not a long-term investment, but in my opinion it was severely undervalued at $14 and is now up more than 35% in the short time since it was recommended.
These are not quite Hidden Gems because they are not always that small. They are usually mid-cap companies that are out of favor, are just not well-known, or are simply mispriced. They are frequently among industry leaders.
In late 2002, I identified private mortgage insurer MGIC Investment (NYSE: MTG ) as seriously undervalued. It was trading at around $44 when I bought, some 37% under my valuation of $70 per share. With my luck, it then fell to $35 -- yes, I mean good luck because I had kept some cash for such an eventuality. I re-evaluated all my notes and could not see any rational reason to change my valuation, so I bought more. Today, MGIC is trading at $68 and has been as high as $77.
A company that I like a lot these days in this category is early Inside Value pick Masonite International (NYSE: MHM ) . Masonite is one of the largest manufacturers of doors in the world and has a tremendous record of shareholder value creation. Maybe it flies under most investors' radars because it is based in Canada or because making doors is boring. Either way, our gain. Certainly, it has escaped being recognized by Value Line's 1700 stock universe, yet the company steadily grows its business each year and now has a market cap of $1.6 billion. It's up 15% since being selected, so it's not the bargain it was a couple of months ago.
So that's the field for the Hunt for Value, and as a value hound how can you resist a free gift for the holiday season? If you like value investing (who doesn't like buying stuff for less than full price?) and want to learn more, you can join us at Inside Value and the first 30 days are on me. No charge. Better still, if you take out a full one-year subscription, you will receive a copy of The Motley Fool Stocks 2005, a $59 value including 12 stock picks from Fool analysts, absolutely free.
Philip Durell is the analyst for the Motley Fool Inside Value newsletter. Philip owns shares inAlderwoods. The Motley Fool is investors writing for investors.