I have a confession to make: I sometimes cheer a good crash. In fact, if it's a really big blow-up, I often revel in the destruction. No, I'm not talking about highway mishaps here. I'm talking stocks.
In Berkshire Hathaway's 1997 chairman's letter, Warren Buffett famously wrote:
If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? ...
Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the "hamburgers" they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.
Buffett's wisdom is the secret of successful value investors from Graham to Ruane and is also the heart of Philip Durell's Motley Fool Inside Value newsletter, where we seek to buy the proverbial dollar for 75 cents. Yet so many, myself included, often forget this crucial strategy at the first blush of a September swoon.
In that vein, here are three examples of why you should cheer as the fire rages.
Cheer your wish list down
You've found a company you'd love to own, but your analysis tells you it's expensive. What do you do? Buy it anyway, or wait?
If you said, "Buy it anyway," you've just made the mistake of confusing a great business with a great stock. Valuation matters. Just ask the investors in bubble-era titans such as Applied Materials (NASDAQ:AMAT) or EMC (NYSE:EMC). Both of these stocks saw expectations outpace reality, and the stocks have both dropped the past few years as a result.
What if you come across that same company making new daily lows? What if, after due diligence, you find improving operations and financials, and a stock trading at ever more compelling levels? Well, if you're like me, you start to cheer that dog down! I'm not unfeeling. I realize there are already thousands of shareholders, many of whom are likely sitting white-knuckled willing the stock to cease tumbling. But I just don't care. (OK, perhaps I am a little unfeeling). I care about what I pay for a company, and I like bargains.
Wishing for lower lows
A recent example is Home Depot (NYSE:HD). The company got onto my watch list in mid-2005. Although the stock had doubled in two years, in the mid-$30's, it still looked relatively cheap. As story after story began appearing about weak retail sales and the popping of the housing bubble signaling the end of the home renovation trend, the uncertainty-hating market kept the stock flopping around between $36 and $42 (and I got out my cheerleading pom-poms ... um, I mean my bullhorn).
You see, stock price aside, Home Depot is a company that has been executing on nearly every front. Annual revenue growth of 13.3% since FY 1999 translated to annual net income and owner earnings growth (net of expansion-related cap-ex) of 16.6% and 19.6%, respectively, over that same period. Management was using free cash not only to aggressively expand the business (I estimate that 80% of capital expenditures are targeted for growth initiatives), but it was also actively buying back shares (share count reduced over 8% since FY 1999) and nearly sextupling the dividend from $0.11 to $0.60 a share. The company also whittled its cash conversion cycle down from a decent 52 days in FY 2000 to an even better 42 days by the end of FY 2005. All indications are that management foresees no immediate slowdown in revenue or earnings growth and believes there are much greater international expansion opportunities to boot. I'd love to load up shares at a sub-$40 price, so bring on consumer negativity and bubble popping!
Then there's the cheering I'm doing to will down CDW Corporation (NASDAQ:CDWC) and slot machine manufacturer International Game Technology (NYSE:IGT) even further. In CDW, you've got a double-digit grower with improving margins, lots of cash being deployed into share repurchases, and strong working capital management. On the International Game Technology side, I'm looking to buy the dominant slot machine provider (I've seen estimates of a more than 70% market share) in time for the next technology upgrade.
Cheer your own portfolio
Peter Lynch once wrote, "The best stock to buy may be the one you already own." Unfortunately, that can be difficult to practice if you've picked stocks that go up.
And that's why I've twice been caught cheering for Garmin to get pummeled. The first time, I wanted to own the stock. The second time was spring 2005. First-quarter growth disappointed the market, and a $62 stock at Christmas became a $39 stock by the end of April. But get this: Nothing had appreciably changed with the company. I started buying more at $40 when the insiders started buying and doubled my holdings. The stock is trading back up to $69 level. With good fourth-quarter results showing the expected robust Christmas sales (researching the online retailers in December showed a very prominent and strong Garmin position), I'm starting to get gleeful again. As a late Christmas gift, could we get a few more downgrades out there and drive this to $50? Please?
Cheer when you shouldn't be
The danger in all of this cheering is that you catch a falling knife and double down before all the bad news is out. Consider what happened when I bought shares in Shaw Group at $22.
Shaw made money on engineering and maintenance contracts from power-plant construction projects. When some counterparties began to default on those contracts, the stock fell from $32 to $16. I cheered that fall and bought more at $16.
How foolish (small-f) of me. You see, I missed a key characteristic of the company's debt. Convertible to equity at a price far higher than the current stock price, the debt also had a proviso for the debtholders to "put" the debt back to the company if conversion was not likely. As the company went cash-flow negative stemming from the contract defaults, it was clear that the put option would be exercised, and Shaw would need to find a lot of cash it didn't have. That $16 stock quickly became a $10 stock.
The Foolish bottom line
The key is knowing when you should cheer on a stock's demise and when you should run away screaming. How do you do that? By knowing the value of your company, the debt structure, the options on that debt, the CEO's middle name ... you get the idea.
That kind of due diligence will help you profit from the market's values, and it's just the kind of due diligence that lead analyst Philip Durell does at Inside Value. To date, he and his team are beating the market by more than three percentage points on the back of 28 active recommendations. To access all of the buy reports and most recent updates, click here to take a 30-day free trial. There is no obligation to subscribe.
Because if you can't knock any holes in your investment thesis, then get out those disaster pom-poms ... I mean, bullhorn. And trust me, no one will think less of you!
CDW and Garmin are Stock Advisor recommendations. Home Depot is an Inside Value recommendation. This article was originally published on Oct. 5, 2005. It has been updated.
Jim Gillies owns shares of Garmin and has the following Garmin option positions: Short Jan. 2008 $35 puts, Short Jan. 2008 $55 puts, Long Jan. 2008 $55 Calls. Cheering on the misfortunes of others doesn't make Jim a bad person, does it? The Motley Fool has a disclosure policy .
