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20

Stocks the Computers Have Thrown Away

Investing is all about predicting the future. When you decide to buy stock, you're essentially saying that the shares you're purchasing are worth more to you than the cash you're handing over to buy them. At the time you buy them, of course, those shares are priced at exactly what you paid, so what you're really doing is predicting that in the future, those shares will be worth more.

The trouble is that for you to be able to buy those shares, someone else had to be willing to sell them to you -- at the same price you paid. That seller looked at the same company you did, and came to the opposite conclusion -- that the shares were worth less than they sold them to you for, and that cash was preferable to hold.

Who's right, and who will win?
In all probability, you're likely up against a rapid-fire, data-crunching computer program. Those high frequency traders actually trade a majority of the volume in the market, especially during periods of volatility. And those programs are in it to win it -- with trading profits measured in the billions, annually, they're there to capitalize on any inefficiency in a stock's price, no matter how small.

Their profits are made from money other investors leave on the table. That's money that's generally not accessible to us mere mortals without ultra-fast network connections, processing power, and sophisticated trading algorithms. Frankly, unless you're already filthy rich and can afford the incredible technological investment, it's not worth your effort to try to beat those machines at their own game.

While those machines are ultra-efficient and effective at what they do, there's one area they're vulnerable to you. And that area is implied by their very name -- high frequency traders. They're not interested in holding onto the shares they trade or owning the companies represented by those shares; they only care about getting in, scraping off their profit, and then getting out.

Your edge over those computers
Where you have the advantage is if you treat those shares you're buying as what they really are -- fractional ownership stakes in a company and the business it operates. While the high frequency traders measure time in microseconds, companies generally update their financial conditions quarterly. Indeed, it may take years for a change in a business's operating strategy to translate into improved profits.

When trade times are measured in microseconds, but business value is generated over years, there's a very real potential for a huge gap to open between a stock's price and a company's value. It's by looking for and exploiting those gaps -- and then waiting for the short-sighted computers to catch up with the long-term reality -- that you have an edge over today's high-tech traders.

One straightforward way to find such opportunities is to look for profitable companies that the market has discarded as being worth more dead than alive. As absurd as that might sound on the surface, in today's right now focused market, you can find a few surprises. Take a look at some of what the market and its microsecond traders served up at the end of last year, for instance:

Company

Price to Tangible Book Value

Trailing Earnings (in millions)

Debt-to-Equity Ratio

Forward P/E Ratio

Long-Term Estimated Growth Rate

Toyota (NYSE: TM  ) 0.79 $2,602 1.09 15.70 22.7%
Arcelor Mittal (NYSE: MT  ) 0.66 $2,483 0.44 6.56 17.9%
Allstate (NYSE: ALL  ) 0.81 $360 0.33 7.55 10.0%
Chimera Investment 0.81 $555 1.85 5.55 8.5%
Royal Caribbean Cruises (NYSE: RCL  ) 0.73 $635 1.04 8.33 30.2%
Rowan Companies 0.90 $749 0.26 10.90 15.3%
E*TRADE Financial (Nasdaq: ETFC  ) 0.81 $139 1.95 11.00 14.4%

Source: S&P Capital IQ, as of Dec. 28.

Every single one of those companies:

  • Is profitable and expected to continue to be profitable,
  • Is estimated to actually grow its business in the future, and
  • Has a debt-to-equity ratio less than two, which indicates it isn't outrageously over-indebted.

Yet they all trade below their tangible book values. That measure is a rough estimate of what the companies would be worth if they simply stopped operating, sold off all their assets at book value, paid off their debts, and distributed what was left to their shareholders. In essence, if book value fairly represents the value of those assets -- which is often a big "if "-- then you're paying a bargain price for the company's assets, and getting a profitable business, for free.

No instant gratification
Of course, it may take awhile for the market to wake up to that fact, especially when there are real issues affecting the company. Toyota, for instance, seemed to be in Mother Nature's crosshairs this year, between the Japanese earthquake and resulting nuclear meltdown and the massive flooding in Thailand messing up its supply chain. They're real problems affecting Toyota's real business, but not even that nuclear meltdown turned into a huge, permanent, and total loss to Toyota's business.

Over time, a good business will likely prevail and reward the shareholders who bought it at a bargain price. It's thanks to that long-term perspective and ability to consider time frames measured in quarters and years rather than microseconds that I feel confident enough in each of these companies to make CAPScalls in favor of them. I've put my own CAPS All-Star rating on the line by handing out green thumbs to their shares in Motley Fool CAPS.

At the time of publication, Fool contributor Chuck Saletta did not own shares of any company mentioned in this article. Click here to see his holdings and a short bio. The Motley Fool owns shares of Arcelor Mittal and Chimera Investment. Try any of our Foolish newsletter services free for 30 days. 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 (9) | Recommend This Article (20)

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 January 17, 2012, at 2:27 PM, PhulishMortal wrote:

    This was a valuable column. TM in particular would be a quality company to own.

  • Report this Comment On January 17, 2012, at 3:07 PM, DCUDFlyer wrote:

    I'm long MT, and have posted my thoughts on the company. P/B is insane...solid yield...BS as solid as steel....bad joke I know.

    ALL is interesting; didnt realize it possessed such a valuation. I'm adding to watchlist, I think I'd still rather have GEICO or Progressive at the moment.

  • Report this Comment On January 17, 2012, at 3:33 PM, Merton123 wrote:

    This article is a classic. Very good stock suggestions. We can beat the machine by taking the fundalmentalist approach. Also there is a wide range of instrinsic values for a stock. Trading on small moves of a stock means that the computer must have figured out the going medium price for the stock. I suspect that the computer may lose money 50% of the time by guessing wrong.

  • Report this Comment On January 17, 2012, at 8:48 PM, Mega wrote:

    Those "Long-Term Estimated Growth Rates" are just silly, especially TM and RCL.

  • Report this Comment On January 17, 2012, at 9:49 PM, TMFBigFrog wrote:

    Hi MegaShort --

    Those growth rates could very well be silly, but notice that in this particular view of those companies, the only thing that mattered was the expectation of positive growth. The valuations looked potentially attractive based on balance sheet measures alone, and any growth was a bonus.

    Regards,

    -Chuck

  • Report this Comment On January 18, 2012, at 12:53 AM, PostScience wrote:

    I have a big problem with evaluating companies based on book value. Royal Caribbean might have a high book value, but how is that value ever going to be unlocked for the shareholder? Unlike cash flow, book value isn't normally paid back in the form of dividends. That leaves the investor hoping for a buyout.

    What's more, book value is easy to manipulate. That cruise ship sitting on the docks may be worth far, far less than it's value on the company's books.

  • Report this Comment On January 18, 2012, at 1:18 AM, TMFBigFrog wrote:

    Hi PostScience --

    You're absolutely correct that straight-up book value can be an easily misinterpreted number. Intangible things like goodwill show up as assets that are not really representened in physical objects and can quicky disappear at the stroke of a 'reinterpretation'.

    Tangible book value (the measure used to pick these companies) is a lot less open to troubles, though the example you pointed out of a cruise ship is a good one. A benefit, though, of looking at tangible book is that the cruise ships depreciate for accounting purposes over time. That means for every new, underutilized ship that may not be legitimately salvagable at its book value, there's likely an "old faithful" that's worth far more operational than it is as scrap.

    Regards,

    -Chuck

  • Report this Comment On January 18, 2012, at 1:19 AM, elixandre wrote:

    @PostScience

    on the other hand, the massive amounts of iron and steel MT has on hand is probably worth far more than is accounted for on the balance sheet -- or is inventory not valued at spot prices for balance sheet calculations?

  • Report this Comment On January 18, 2012, at 10:46 AM, barakn wrote:

    Funny that the value of cruise ships are brought up in this discussion, considering the recent disaster in Italy has caused much discussion of whether the design of modern cruise ships sink causes them to sink faster than they ought to. There's also a good chance that the industry as a whole will be intensely scrutinizing their ship captains for signs that they may take too many shortcuts or are of the type of personality that would abandon ship prematurely. And the customer base may dwindle for a year or more until the public loses sight of this disaster in the rear view mirror.

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Chuck Saletta
TMFBigFrog

Chuck Saletta has been a regular Fool contributor since 2004. His investing style has been inspired by Benjamin Graham's Value Investing strategy, and he manages the real-money Inflation-Protected Income Growth portfolio on Fool.com based on many of Graham's principles. Chuck also can be found on the "Inside Value" discussion boards as a Home Fool.

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