"Give me your tired, your poor,
Your huddled masses yearning to breathe free,
The wretched refuse of your teeming shore,
Send these, the homeless, tempest-tost to me,
I lift my lamp beside the golden door!"
-- From "The New Colossus" by Emma Lazarus
This famous poem is mounted on the base of the Statue of Liberty, reaching out to those rejected everywhere else. It might not seem evident, but there's a strong parallel between Lady Liberty's call and an investor's search for value. Both are looking to accept others' discards.
It takes considerable courage to accept society's rejects -- be they debtors, heretics, or the scandal-plagued shares of mortgage financier Freddie Mac (NYSE:FRE). Thanks to last year's accounting debacle, shares in the giant, government-sponsored entity tanked, only to recover nicely in the intervening time. For a while, though, Freddie's shares could be found at a discount to their intrinsic worth for investors willing to accept the uncertainty of accounting restatements and changes to the company's business practices. Philip Durell, author of Motley Fool Inside Value, addressed Freddie Mac in a special report. He called the company a "fallen angel." Its problems made it the "wretched refuse" of Wall Street, providing an opportunity for significant profits for value-seeking investors.
Uncertainty and rejection surround many value investments. After all, were the underlying companies' prospects known and known to be good, the stock prices would already be higher. For example, when Bank of America (NYSE:BAC) announced it would be buying FleetBoston -- and unveiled its high offer -- fellow Fool Bill Mann directed some much-deserved scorn at the acquiring bank. I, on the other hand, thought that while the price paid for FleetBoston was high, the market's punishment of Bank of America made it a compelling value. He and I shared a few words over that disagreement, though we remain as close as a Blue Devil and a Tar Heel can be.
As two (usually) rational people, Bill and I nevertheless looked at the same data and came to opposite conclusions. The stock market works precisely because people disagree with one another. When too many people share the same positive opinion on a company or on stocks in general, the result is often what Federal Reserve Chairman Alan Greenspan called "irrational exuberance." Of course, the market's irrationality can extend to pessimism, as well. When irrational pessimism drives stock prices too far below what their underlying businesses are worth, value investors get interested.
Often, irrational pessimism comes with justified concerns. Just a few months ago, Merck (NYSE:MRK) sported a Triple-A (AAA) debt rating -- the highest available, and one bestowed on a mere handful of publicly traded companies. With such a pristine balance sheet, glowing reputation, and historically envied research-and-development arm, even its aging arsenal of patent-protected compounds and a new-product pipeline slow to refill couldn't permanently derail the company.
Now, since the withdrawal of painkiller Vioxx, the company's market value has been slashed. A portion of that reduction was due to a legitimate revaluation of the firm without one of its cash cows, but probably legitimate and currently unquantifiable litigation concerns are keeping the price low, as well.
Will Merck end up another casualty of lawsuits, like so many asbestos companies? Or will it, like cigarette giant Altria (NYSE:MO), survive and recover in spite of the litigation and any potential settlements or verdicts? In all honesty, my crystal ball is still broken, but as an asthmatic dependent on Merck's Singulair to maintain my quality of life, I certainly hope the company survives.
And if Merck survives, will the internal changes forced by this crisis help it thrive in the future? It's very possible to win a battle but lose the war. Just ask auto giants General Motors (NYSE:GM) and Ford (NYSE:F). In spite of job cuts, union concessions, and other cost-cutting measures, their market share continues to erode, their cash incentives for new-car buyers continue to escalate, and solid, sustainable manufacturing profit continues to elude them.
When searching for value-priced companies, it often pays to look at the fallen angels -- companies that, often due to their own, self-made problems, have temporarily left the good graces of Wall Street. The key is to find companies whose problems can and will be fixed, and to invest while market sentiment is still sour and the firms are trading below their intrinsic values.
Fool contributor Chuck Saletta owns shares of Merck and Bank of America. The Motley Fool is investors writing for investors.
