How Can Investors Justify Buying Beaten-Down Stocks?

Just because a stock's price has dropped doesn't make it a great buy. In this segment of Backstage Pass recorded on Jan. 28, Fool contributors Toby Bordelon, Jason Hall, and Jon Quast discuss the importance of looking beyond stock price and focusing on the underlying business before investing in a company. 

Toby Bordelon: You've got some thoughts, Jason, that you haven't shared yet?

Jason Hall: I always do, Toby. You know the answer to that.

Toby Bordelon: I know you do.

Jason Hall: I don't know. I'm trying to be thoughtful about how I think about this. I shared that chart earlier. I'm going to share it again. Because I want to name the stocks. I want to name these companies. The purple one, the third best performer, is the meme-stock, that's AMC Entertainment. Cloudflare is the blue one, ticker NET, CrowdStrike ticker CRWD is the yellow one and then the green one is Magnite.

This goes back two years ago today. I'd just picked that, randomly picked that day when I was making the chart and I was talking to these guys and I'd like, "Holy, I thought it was going to be all holier than though, and I saw this and I'm like, damn, that's a gut check. It really is.

How do I know the difference between, in the moment, it's tough. It really is. I want to acknowledge that first. We go through those same emotional experiences that everybody else does. The fear and greed, the pain, the pleasure. We experienced, all of those same things.

But I think at the end of the day, part of it is like going through the exercise of that trying to rationalize why it's worth what it's trading for now. But understand what I think it can be worth in the future and why paying today's price make sense or doesn't make sense. It's really separating those.

What do I think about? Think about things like total addressable market. What does the company say their addressable market is today? Then verify that against some other sources. Don't just trust the company. Think broadly, industry resources about addressable market and that sort of thing. Then think reasonably, OK, how fast is that market growing?

Reasonably, how much can that company capture? What is the multiple it's trading for now? What is the range that it's traded for over the past few years? If this company is five times larger in revenue or ten times origin revenue when it gets to that period. What's the multiple going to look like then?

What's that going to be worth? So just doing some basic math, applying a little bit of critical thinking and then thinking about down the road. I try to be thoughtful and mindful about that and using weird stuff like thinking about AMC, it's worth $8 million a theater. No, it's not. It's trading for $8 million of theater.

We've got somebody that's asking about Cloudflare trading for about 50 times sales. Is it worth 50 times sales? Probably not. The business today, no. But people are betting on what the business is going to be worth next year, five years, 10 years from now.

That's what that valuation is trading for. You have to think about that valuation that you buy it for today. But what would it be worth in some potential future? A range of outcomes that you'd be acceptable with. I think that's what you have to decide. That's what I try to do.

Jon Quast: Jason, if I can just jump in here with what you're saying.

Jason Hall: God, please jump in. People are trying of hearing me.

Jon Quast: [laughs] Based on the chart that you showed. I think that what separates the memes from the real deal, and it is the earnings growth. We believe that over, given enough time, stock performance will correlate with earnings growth. If you go back to the six principles of Foolish investing, target  five to 20 year returns. You just showed the chart over two years and we're showing that over a two-year span, we haven't even done better than a failing movie theater.

Some of these picks have been just, we could have just thrown a dart board, we could have flipped the coin. It would've made no difference in the two-year returns. We have actually not done so well. But when you think about earnings growth and so Vihaan comments, I wish I would've invested AMC too. Yeah, me too, but the only --

Jason Hall: The reason you didn't invest in AMC, it's well, I can't speak for you. The reason.

Jon Quast: Go ahead. 

Jason Hall: We weren't recommending that stock at the Fool, you didn't see it recommended. The reason I wasn't buying it is because it was a crappy business here too.

Jon Quast: Even in the best of times, how is AMC going to grow it's earnings in excess of what the S&P 500 average return is going to give you?

I don't see that in the best of times and it's certainly wasn't the best of times for AMC. It continues to not be so a company like Magnite by contrast and somebody asked about that. You bought it at the highs. Yes, that's no fun. But has the thesis changed, no?

If anything, maybe it's added some debt to the books, but it's actually gotten better because it's made some acquisitions and it has taken market share and it has proven to have a very sticky customer base and long-term, you talked about addressable market. Where is everything going? It's going from traditional TV to connected TV and the ad dollars are following.

Magnite, very well-positioned, hasn't done great as a stock over the last two years, well, it has, but it hasn't even done as good as AMC. But I believe that it's going to continue growing it's earnings over the next five years. I would expect the stock price to eventually reflect that.

Jason Hall: Jon, I'm going to point toward PubMatic too. I think if people are looking at that side of the ad-tech space, they may also look at PubMatic for two reasons. I'm a big Magnite investor. Pubmatic, I'm going to buy soon, as soon as I stop doing what I'm doing right now. The thing that I prefer about PubMatic right now is their organic growth has been better.

Magnite has grown a lot through mergers and acquisitions activity. I think PubMatic's growth, organic growth model. I think there's something to be said about the durability of that. But I do like them both because of the secular opportunity.

Jon Quast: I agree with you, Jason, Magnite was in my five favorite stocks in October, if I rewrote it today, PubMatic would take Magnite's place. Doesn't mean I don't like PubMatic, I like it.