Junk. mountains of it. About this time last year, my garage had been overtaken and was in desperate need of some rearranging -- and I'm not talking about run-of-the-mill spring cleaning. The heaps of unrecognizable clutter would have made Fred Sanford proud. I'm still not entirely convinced that a tornado didn't just sweep through unannounced one night. Whatever the cause, something clearly needed to be done. So my wife and I arranged the fishing tackle, spare furniture, outdated electronics, and whatever else wasn't nailed down into a semi-orderly state, threw up a few signs around the neighborhoods, and had a garage sale.
I wasn't sure how the turnout would be, but sure enough, bright and early one Saturday morning, there they were. Before the morning paper had even been delivered, I found a throng of people milling around inside my garage, scouting high and low in search of treasure. I think a few even came inside to make me an offer on my TV. At the end of the day, I was left with an empty garage, some spare change in my pocket and a valuable lesson: People love a good bargain.
Rock-bottom prices explain part of the appeal of a garage sale, but there may be an even stronger driving force involved. After all, you'll find row after row of inexpensive merchandise at Dollar General (NYSE:DG), but seldom do I see shoppers waiting there patiently in the pre-dawn hours to get the first shot at the best deals. No, much of the mystique lies in the unexpected. Only at garage sales do adults' imaginations run as wild as a child's on Christmas Eve. There could be almost anything inside: vintage baseball cards, a hardly used pool table, even an original Picasso just waiting to be discovered.
Wall Street's garage
We sometimes forget that the primary goal of successful investing has nothing to do with finding perfect companies -- and everything to do with finding undervalued ones. Wide economic moats, superior competitive advantages, pristine balance sheets, expanding margins, and staggering growth rates are all great, but they're also easy to spot. Companies that exhibit all of these attributes are like polished gems in a jewelry store showcase -- easy to appreciate, but hard to afford. Of course, the companies that are easy to afford generally became that way for a reason. Putting these specimens under a financial microscope will almost always reveal a few flaws.
So where do investors find these wide discrepancies? I would suggest starting in Wall Street's vast garage, where an impatient Mr. Market has thrown in the towel on stocks that have been hammered by scandals, bankruptcies, and restructurings. Forget the swanky, high-end market boutiques. This is the place where fallen angels and turnaround plays languish in dark corners-- and where the value investor shops.
Seeing what others don't
Stocks can get battered for just about every reason imaginable: an earnings shortfall, rising oil prices, strong economic data, weak economic data, rainy weather. anything. To be sure, many of the stocks deserve the painful floggings they receive. In some cases, though, the harsh punishments from an unforgiving investment community just don't fit the crime. These beaten-up, deeply out-of-favor companies are worth exploring further -- particularly when they come with a catalyst for positive change.
While shopping for these misunderstood garage sale stocks, Motley Fool Inside Value editor Philip Durell will always pick them up off the table, shake them a few times and check to see that all the important pieces -- positive free cash flows, attractive tangible assets, competent management teams and so on -- are all still attached.
It takes a special eye to see treasure where others see only junk. Last August, MCI (NASDAQ:MCIP) was truly a firm that only a value investor could love. The embattled long-distance carrier was emerging from bankruptcy, facing its fourth straight year of sharply falling revenues, bleeding red ink, and operating in some of the least promising areas of the distressed telecom industry.
The Admiral of the Inside Value team saw something different, though. Instead of a firm beset with problems, he saw a streamlined company with a scaled-back workforce. He also saw a company that had been purged of the bulk of its debt by bankruptcy court; a company still generating healthy operating cash flows; a company with a new but battle-tested leader in Michael Capellas, who had previously steered Compaq into its merger with Hewlett-Packard (NYSE:HPQ); and a company with a successful track record of servicing and retaining the valuable business of large multinational corporations and government agencies.
Keeping all of that in mind, Philip's extensive valuation work yielded an intrinsic value of $25-$30 per share for MCI, at a time when the company was trading for little more than $13. Mr. Market wanted nothing to do with MCI and slapped a half-off sticker on the stock just to get rid of it. The Inside Value team proudly carried the stock home and made it the first selection in the newsletter's inaugural issue. Today, after becoming the target of a fierce bidding war between Verizon (NYSE:VZ) and Qwest (NYSE:Q), the shares have climbed above $26 -- setting the tone for future winning picks.
Get there early, and don't be afraid to haggle
In the sale that Wall Street puts on each day, there is no need to ask whether anything in the $0.50 8-track-cassette pile can be dropped to a quarter, but it still pays to be frugal. If a certain stock is a tad out of your price range, keep on browsing -- there are plenty of items to choose from. Like any garage sale promoter, Mr. Market sets out plenty of true junk on display, but he is also willing to part with some quality items. Unfortunately, his merchandise is not laid out in neat rows for easy inspection, and the bargain-minded shopper must do some digging to uncover the best buys.
Credit card issuer Providian (NYSE:PVN) was a late-1990s success story, as it captured much of the market for the least creditworthy segment of borrowers and compensated for the higher credit risk by charging higher interest rates. But in 2001, the bottom fell out of the subprime market. The company had to write off a huge chunk of its loan portfolio, was hit with a hefty $300 million fine, and was forced to increase its capital reserves. By November, the stock had shed 95% of its value, dropping to a low of $2.00. By then, though, the company had already shifted its focus to mid-level borrowers, thereby increasing credit quality and reducing charge-off rates. Providian now trades at around $17 after announcing solid loan growth and better-than-expected earnings.
Enjoy the company
Unlike real garage sales, where people are forced to elbow their way to the most popular items, value investors don't often have to fight a crowd. They may even run into the likes of Warren Buffett or Bill Miller, who, like many other legendary investors, became famous by identifying downtrodden and underpriced value stocks -- not by chasing after the hottest new technologies.
It stands to reason that in a down market, value sectors offer a higher margin for error than their more growth-oriented cousins can. That protection, however, does not necessarily come at the expense of possible capital appreciation. In the 34 years from 1968 to 2002, value stocks as measured by Ibbotson returned 11% per year, easily outpacing the 6.5% earned by the broader S&P 500. Over that same period, a $1,000 investment devoted to value would have grown to $34,630 -- quadruple the S&P's $8,471.
The market won't advertise its sales, so stay vigilant and keep your eyes open. And when you do find a great deal, don't be afraid to roll up your sleeves and reach your hand to the bottom of the bargain bin. Oh, and if you find one, would you mind picking me up a Picasso?
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Fool contributor Nathan Slaughter is making plans for his second annual garage sale. He owns none of the companies mentioned. The Fool has a disclosure policy.
