The Motley Fool Hidden Gems team spends a lot of time talking stocks. Seriously. Given the choice between hanging out with us and watching glaciers flow, and most folks will head home to pack the earmuffs and long underwear. So pack your crampons, folks, because early this week, I asked the team to reflect on the surprisingly good earnings from Hidden Gems portfolio candidate Autoliv
This week, car safety equipment manufacturer Autoliv reported better-than-expected numbers, and the stock enjoyed a nice bump-up. Analysts were surprised by both its revenue tally and its profitability. When we recommended this company to Motley Fool Hidden Gems members in our March 2009 issue, it was, to put it politely, not a welcome idea. Car sales were terrible and getting worse. General Motors and Chrysler were teetering on the brink. Many thought Ford
The outlook is a little bit sunnier today. Auto sales have rebounded (ever so slightly), and to date, Autoliv shares have returned more than 100% since our recommendation. What lessons can this story teach small-cap investors?
Nate Weisshaar, senior analyst:
I think the lesson for small-cap investors is to look for the Rolex in the wreckage. The auto industry has slammed into an abutment, but we are still going to be driving cars for the next couple of decades (unless the administration's plans for nationwide hamster tubes are implemented). With Autoliv, we were able to look past the smoke and airbag dust, as well as the combination of some short-term credit issues and a bout of questionable capital management, to find a best-of-class operator with an increasingly important niche in auto safety. While the outlook for the overall industry looks bleak over the next few years, Autoliv's focus on efficient operations should mean it will be part of the exclusive club of last auto suppliers standing.
Mike Olsen, senior analyst:
What Lao Tzu taught us in that college philosophy class: "The words of truth are always paradoxical." Take one part emotion, one part uncertainty, and one part financial crisis. Mix with a fundamentally good company, subject to already horrible industry conditions. The result: an unbelievable range of possible outcomes. Truth told, Autoliv looked cheap, and it was. But it could've been cheap for good reason: GM and Chrysler were on the fritz, while Autoliv faced the possibility of some big operating losses and continues to deal with very beleaguered consumers. This pick worked out great, but remember, it wasn't a foregone conclusion in January.
The lessons are twofold. First, the market can be, and sometimes is, totally irrational. That can bring untold opportunity. But second, what sometimes appears incredibly cheap -- or irrational -- isn't entirely unfounded. In investing, truth often manifests itself in shades of gray. The challenge for small-cap investors looking at distressed goods is separating the Autolivs from the Select Comforts.
Stan Huber, senior analyst:
It is important to remember that Mr. Market will often overreact both in times of euphoria and utter depression. This is particularly true for small-cap stocks because of the lack of active coverage. Early this year, we cut through the doom and gloom and took a hard look at Autoliv. We saw a company with a history of managing through cycles, a strong competitive position, and a stable management team with demonstrated capital allocation skills. Further, the company was priced at a level that implied new car sales would fail to equal historical scrap rates forever.
With industry trends toward smaller and lighter vehicles in which safety is an even greater concern, it seemed apparent that the market had overreacted to the downside. With the small companies in the Motley Fool Hidden Gems universe, an individual investor has the opportunity to profit ahead of the crowd by shutting out the TV talking heads and digging into the economics of a specific business.
Jim Gillies, associate advisor, Motley Fool Hidden Gems:
Warren Buffett has famously (and repeatedly) warned that, "You pay a high price for a cheerful consensus." To this, I offer Jim's corollary: "Embrace paying a cheap price for a cheerless consensus."
When we recommended Autoliv, we did so against a brutal stream of negative auto industry headlines. Autoliv's history of market dominance and oversized cash generation was ignored, as was the notion of the "coiled spring" building up in the industry (by this, I mean a vehicle scrappage rate exceeding new purchases by roughly one-third), and the limited exposure to troubled Chrysler and GM.
You don't, of course, charge blindly into any cheerless consensus (many of them are well-deserved). But after "kicking the tires" and seeing that Autoliv traded at about 70% of a valuation that assumed five successive years of U.S. auto sales below 10 million (the last single year racking up such a number was pre-Ronald Reagan's presidency), Autoliv was, forgive me, as "safe" a recommendation as I've seen.
Seth Jayson, Motley Fool Hidden Gems co-advisor:
Since January, Autoliv has been a constant reminder for me to remember how much I don't know. (It upped the ante this week and left me with a busted crystal ball when, just before its earnings bonanza, I moved it from our Team 1 to Team 2, for valuation reasons.) But while we need to embrace our ignorance, there is a point at which you can buy despite your lack of foresight. And although we were pretty sure about that point when we recommended Autoliv to our members at $15.75 per share, we whiffed on adding it to our real-money portfolio in the low $20s. We were a bit anchored to that mid-teens price, and in the end, we lost out on a chance for a pretty quick 50% gain, because we were holding out for a shot at a double. That was a mistake, and in retrospect, the reasons why are more obvious.
Unlike a big, opaque bank such as Citigroup
Andy Cross, Motley Fool Hidden Gems co-advisor:
After the financial meltdown went into high gear last fall, investors lost any appetite for risk. Short-term Treasury yields collapsed as the Federal Reserve became the safe haven for risk-averse investors. "The investment world has gone from underpricing risk to overpricing it," Warren Buffett, chairman of Berkshire Hathaway
We weren't completely immune to that at Motley Fool Hidden Gems. As Seth mentioned, we recommended Autoliv in the mid-teens, but after starting our real-money portfolio, we froze up -- kind of like the credit market that threw everyone, including Autoliv, for a loop. Autoliv's debt position held us back a bit. We learned from that experience, and one response was our creation of the Rough Cut designation for stocks, like Autoliv, that have plenty of upside but also big unknowns that could sink them. Rough cuts with potential debt issues can be volatile, though, so we will tread lightly by allocating just a small percentage of the overall portfolio to them. Our usual purchases have stronger balance sheets, like cash-rich Atheros Communications
Foolish final thought
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At the time of publication, Seth Jayson owned shares of Berkshire Hathaway, but had no position in any other company mentioned here. Berkshire Hathaway is a Motley Fool Stock Advisor recommendation and a Motley Fool Inside Value pick. Autoliv is a Motley Fool Hidden Gems portfolio candidate. Atheros Communications and Autoliv are Hidden Gems recommended stocks. The Motley Fool owns shares of Berkshire Hathaway and Atheros Communications and has a disclosure policy.