Imagine that you're an NBA team owner (something I do every day). Unfortunately, if you've got your eye on Kobe Bryant, the problem is that Lakers owner Jerry Buss isn't about to part with his best player. Also, if you wanted to acquire Kobe's services, you'd have to pay him a boatload of money because if you don't, someone else will.
So what to do? What if you could wait until Kobe goes into a slump and then offer a low-ball price? Better yet, what if Kobe had temporary problems, such as the flu, and performed poorly for a couple games? Wouldn't it be great if you could get Kobe on the cheap because of temporary and fixable problems?
Unfortunately, this just doesn't happen in the NBA. NBA owners aren't shortsighted and aren't about to dump their best players because they caught a cold. But to my everlasting amazement, investors in the stock market just don't think this way. You can often buy stock in companies at extremely cheap prices because of a "flu" that resulted in short-term problems. In fact, the bread-and-butter strategy for many value investors is to buy the best companies in out-of-favor industries.
Limit downside risk
The best reason for investing in depressed industries is because much of the bad news is already priced in. After all, assuming the industry isn't based on an obsolete technology, every depressed industry has to hit bottom at some point. Consider this riddle: You're running into a forest. At what point are you running out?
The answer is halfway. In other words, it's darkest before dawn. As long as you do your homework and buy with a sufficient margin of safety, there's no better way to limit downside risk and maximize upside potential than in investing in great companies in out-of-favor industries. When the cycle turns, these investors will benefit both from a rising tide and having a low cost basis in a great company.
However, catching a falling knife is scary, and there's nothing to stop a bad storm from getting worse. For that reason, I believe investors should focus on minimizing downside risk. Although nothing can replace doing some old-fashioned homework before making an investment, investors would be well-served to go through some general guidelines before investing.
1. Do I have the stomach for this?
I can guarantee that investors plunging into depressed industries will feel short-term pain, because it's impossible to pick a bottom. If you aren't prepared to stomach losses, then you'll almost certainly sell out when the stock falls and take a hefty loss. I remember reading that Warren Buffett's investment in Washington Post (NYSE:WPO) initially lost around 20%. It would have been a shame if Mr. Buffett sold out when the chips were down, because his Washington Post stake has increased in value from (note: I'm typing these out for effect) $11,000,000 to roughly $1,260,000,000.
2. Am I confident in the industry's economic drivers?
Advertisers pay newspapers like New York Times (NYSE:NYT) because they want to sell stuff to readers. If there are fewer readers, then advertisers won't pay as much, and newspaper readership has been declining for years. Will this change? Maybe someone out there knows, but I don't, so I'm not putting my money in, because chances are I'd sell my stock at a loss at the first downturn because of my lack of confidence. On the other hand, I do believe the economics for cable television companies such as Discovery Holdings (NASDAQ:DISCA), whose main asset is 50% ownership in the Discovery channel, are stable and predictable. Even after my original investment fell 10%, I was willing to invest more at a lower cost basis. Although this investment hasn't been a big winner, I believe the fact that I invested in an industry with predictable economics gave me the confidence to avoid selling at a big loss.
Most importantly, investors should avoid industries where they don't understand the economic drivers. I've met quite a few people, who, after being told that I was an analyst, proceeded to give me tips on how I should get into ethanol stocks. (Incidentally, a profession in asset management is probably one of the few where people are more likely to give you tips than ask for them -- when's the last time you told your doctor a better way to perform a surgical incision?). Anyways, the last thing I'd feel comfortable doing is predicting how much money ethanol producers will be making in five years. If I'd been invested in ethanol, I can guarantee I would've gotten creamed for a huge loss, and if ethanol stocks rebound in the future, I'm sure I wouldn't have stuck around to enjoy it.
3. Does the company have a sustainable pricing advantage?
This is probably the most important question an investor can ask about a company. If a company has a sustainable pricing advantage, it can most likely charge a price high enough to make a profit, and if it's making profits, that's a good thing. More importantly, if you get unlucky and invest in a bad situation that gets worse, a pricing advantage allows a company to ride out the storm.
In 1999, the average price of wallboard was $153 per thousand square feet, and in 2001 it was $85. Because of the 44% drop in prices, many wallboard producers had to close up shop. The ones that survived, such as Eagle Materials (NYSE:EXP) and USG (NYSE:USG), had pricing advantages on account of their lower cost structures. When competitors closed plants because they just couldn't sell at such low prices, these companies increased their market share. When wallboard prices rebounded, these companies benefited the most. Having a pricing advantage means that during shake-outs, competitors will go bankrupt first, which results in less competition for the survivors and increased market share. I should also add that investors should also seek out healthy balance sheets for an extra protective layer when a big storm hits.
4. Are people smarter than me at investing?
This is a somewhat controversial point. Many investors are not full-time money managers or analysts, so they'll never be able to visit or talk to management, spend 10 hours a day for weeks or months researching a single investment idea, and talk to numerous people in the industry in order to get a holistic view.
Miners put canaries in mines in order to alert them to poisonous gas. If the canary stops chirping, they know they should get out quickly. I believe there's no shame in investors using the best value investors as canaries. If you've done your homework on a company and believe it's worthy of an investment, and someone who you know is successful is already invested in the company, then you can take comfort in the fact that that someone probably did a lot more homework and addressed red flags that you didn't. I'm not advising that investors blindly piggyback, but instead that they look for confirming evidence from investors with great long-term track records.
I've obsessively studied the great value investors for years, and I've seen them profit by wading into the wreckage of depressed industries and picking out the survivors -- the ones who have strong balance sheets, pricing advantages, and stable future economics. In the end, I always come to one conclusion -- so that's how they do it.
Discovery Holding is a Motley Fool Inside Value recommendation, while New York Times is an Income Investor pick. Take the newsletter of your choice for a 30-day free spin.
Fool contributor Emil Lee is an analyst and a disciple of value investing. He has a long position in Discovery Holdings and appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.
