Pattern Recognition
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By Mithrophon
June 8, 2007

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In writing about FedEx and ConAgra recently, I mused that FDX doesn't look much at all like my typical stock idea, while CAG had many similarities. This led to me thinking a good bit more about my "template", so to speak. What characteristics would my best investment ideas typically have?

Keeping in mind that I'm a contrarian value investor typically focused on turnaround situations, here's the list of attributes I'm looking for in a stock (in no particular order):

Under-earning (or non-earning) assets - I'm looking for companies whose current margins are not representative of their potential margins. Usually this is simply because performance has been weak across the board, but sometimes the company is doing really well in some areas but has a division that's break-even or below. Many analysts will just apply a P/E multiple to the earnings stream without accounting for the piece earning nothing.

New management - Frequently, new management provides an outstanding catalyst for change at a company that's not performing as well as it could be. It helps if the new management has an identifiable track record of success, whether they come from outside or inside the company they're now leading.

Solid valuation support - When a company is earning far less than it should be, it's important to find non-earnings based metrics that show the downside risk is limited. This can be EV/Subscriber for cable companies, EV/Bed for hospitals, P/Book for financial companies, EV/Sales for mature retailers, etc. The more private market transactions you can find to support these metrics, the better.

Smart capital allocation - Has the company been doing things with its discretionary free cash flows that make sense? Whether it's share repurchase, dividends, acquisitions, capex, whatever, it's important to see that management is acting in shareholders' best interests.

One time issues set to resolve - A lot of times, a potential turnaround investment is beset by a some unusual item, be it competitive, legal, regulatory, whatever. Investors tend to extrapolate risks associated with these issues excessively, providing opportunity and catalysts upon their resolution.

Secular growth potential - Turnaround investments work best when time is on your side. If the company participates in a stagnant or declining market, then passage of time can reduce the value of the enterprise. On the other hand, if the underlying markets are growing, then frequently the investment (if made at the right price) can succeed whether or not your specific thesis turns out to be correct.

Strong balance sheet - Again, turnaround investments work best when time is on your side. Large interest payments and negative free cash flow can put a short fuse on the investment, requiring the turn to come before the bomb goes off.

Good corporate governance - What does the Board of Directors look like? Are they smart people who understand financial markets? Or are they moderately successful local businessmen likely to be overly impressed by the CEO? The former is good, while the latter can be indicative of a situation that will be much more difficult to change if things start going badly.

Negative Street sentiment - I think we all agree that Wall Street research is borderline useless for great proprietary insights, but I think it does provide a useful gauge of sentiment for companies that are followed by more than 5 analysts. If 2/3rd's or more of the Street analysts have a Hold or Sell on the company, it's typically a good sign that general investment sentiment around the stock is negative, providing opportunity for mis-pricing to occur.

Under-followed stock - Similarly, there are many companies that haven't yet gotten good Street coverage relative to their peers, or have something very confusing about them (such as multiple divisions, with the Street focusing on the wrong one). These situation can lead to mis-pricing.

Other smart shareholders - It's never a bad thing if a low turnover, long-only firm you greatly admire (Dodge & Cox, Southeastern, Brandes, Harris, Pzena, etc) has a large position in a company you're analyzing, especially if they've been buying recently.

Insider buying - While it's tough to get good signals from insider sales, large insider purchases are difficult to interpret negatively.

Hope this is helpful. Obviously, what works for me might be useless to someone else, and this is heavily biased towards contrarian turnaround situations. But it's helpful for me to write all these down, as before they were just floating around in my head. Anyone have any others to add?

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