What makes you so special?
"Special situations" investing is tricky, especially for us Joe Six-Packs. The very notion flies in the face of plenty of academic theory, which proposes, with the efficient-market theory, that news is always priced into a stock.
Luckily for us, efficient-market theory is just that -- a theory. If it weren't, you and I would be insane to try and buy individual stocks. We'd buy our index funds, sit down with the six-pack, and wait for capitalism to work its long-term magic. But markets are only efficient -- if ever -- over the long term. Over the short term, panic, paranoia, irrational exuberance, and good old-fashioned neglect do offer us the potential for profiting from the market's inefficiencies. And this can happen frequently with "special situations," which I define very loosely to mean "situations where Mr. Market ain't thinkin' straight."
What's your specialty?
That definition casts a very broad net. Colleagues of mine, such as Jim Gillies and Bill Mann, are adept at picking through the more complex of these situations, like finding stranded assets on the verge of getting unstranded, or evaluating intricate spinoffs before the crowds figure out what things are worth.
Me, I hunt simpler game. I look for opportunities in retail "comebacks" and "turnarounds." There are a couple of good reasons for this. One is the volatility of retail. Because the market pays way too much attention to short-term sales figures, retail offers good opportunities to get fine companies on the cheap, with a new batch of prospects every month. The other is that retail operations are fairly simple to evaluate. That means I can analyze more opportunities more quickly, and my odds of making an error are smaller.
What's the deal with retail?
Big retail is a simple, classic leverage game. Once the elements of infrastructure -- like headquarters, stores, and sourcing, manufacturing, and distribution networks -- are set up, they scale very well. Done right, that means that given their relatively fixed costs to operate, incremental revenue increases flow disproportionately to bottom-line cash profits.
This explains why well-run retailers can grow earnings so nicely for so long, even in the face of periods with flattish same-store sales. With major costs fixed, or growing at a slower pace than revenue increases, profit growth outruns revenue growth. But this is a double-edged sword. Leverage also works the other way. Once a company's sales dwindle, profit growth can sink very quickly. But the Street's constant fear of this is your advantage, if you use it wisely.
To me, the easiest "special situation" to spot is the "comeback." This is my term for a retail stock that's been pushed down for reasons unrelated to core operations. American Eagle Outfitters (Nasdaq: AEOS ) in the fall of 2005 is a prime example. The stock was brutalized after a couple of months of lackluster sales. The Street feared that the end was near, but a look at leverage exhibited in American Eagle's margins showed that it was likely to continue experiencing strong earnings growth even if sales weren't as bubbly as Wall Street hoped they might be. I bought handfuls, and advised others to do the same, and the stock returned more than 100% for us in just more than a year. Best of all, the only thing American Eagle had to do was keep doing what it was already doing.
Don't get dizzy
Turnarounds are trickier territory. When I think "retail turnaround," I think major changes: retooling of the distribution networks, major upgrades to stores, new blood to reinvent the brand. These are the kinds of changes needed to reinvigorate retailers like Gap (NYSE: GPS ) , Home Depot (NYSE: HD ) , and Wilson Leather (Nasdaq: WLSN ) .
Retailers reach this stage when years of underperformance make it clear that the old formula's not working. The trouble is, the new formula may not work, either -- the turnaround may never turn around. Gap, for instance, has been "turning around" for years. Ditto outfits like Pier 1 (NYSE: PIR ) .
Turnarounds can be worth waiting out, but only at the right price. Gap stock continues to carry a price that presumes a turnaround is already occurring -- and it most certainly isn't. If it ever comes, odds are, we won't see much of a return.
The real trick
We need to find those special situations, the companies that are still priced for failure. Even better is being able to get them when they already show evidence that they are, indeed, turning around.
I began buying shares of Guess? (NYSE: GES ) back when it was still about $6.80 a share (in split-adjusted terms). I did so because it was quite obvious that the company was already turned around, but the Street failed to appreciate it. After having survived some terrible, bubble-era sales drops, the company had finally grown up and paid more attention to modernizing its sourcing and supply chain. It took a disciplined approach to store closings and openings. It brought a new attitude toward responsible growth and capital allocation, and the improvement was crystal clear in the expanding margins.
The Street seemed frightened, possibly because, when I bought, the shares had already been a quick double, but I could see the trajectory that earnings were going to take once the leverage in the Guess? retail model began to kick in. And if I could see it, anyone else could have. The shares were clearly worth more, but why weren't they trading there? Quite simply, the market was looking at spicier tamales, like True Religion (Nasdaq: TRLG ) . Guess? had been written off.
Of course, it didn't hurt that the top line at Guess? expanded at a 20% clip for a while, but this drove earnings increases in the 50% to 100% range. The stock became a very quick five-bagger for me and the wife -- who originally found this idea.
A special sayonara
Situations like that one are, I would argue, very special. And they don't come around very often. Markets may not be perfectly efficient, but bargains don't go unnoticed forever, and in today's "hooray for everything" atmosphere, finding underappreciated stocks is no easy task. But they do appear, and it takes a special kind of mindset to recognize them when they come. Looking at the popular stock and dreaming of the big time is amateurish and likely to lead to subpar returns. But if you can find the simple turnaround situations in the market's castoffs, and you're strong enough to trust your own data and analysis, you'll find those five-baggers while everyone else wonders what makes you so special.
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Home Depot and Gap are Motley Fool Inside Value selections. Lead analyst Philip Durell loves a good turnaround, and he's recommended a few. To see what they are and how they're helping Inside Value beat the market, click here for your free 30-day trial.
At the time of publication, Seth Jayson had shares of American Eagle and Guess? but had no positions in any other company mentioned here. See his latest blog commentary here. View his stock holdings and Fool profile here. American Eagle and Gap are Motley Fool Stock Advisor recommendations. Comments? Bring them here. Fool rules are here.