The mission of the value investor is simple: we want to find companies trading at prices less than their fair value. In some cases, companies are below fair value simply because the market has failed to appreciate the sustainability of a company's competitive advantage. At other times, like now, companies fall below their fair value during a crisis, when panicked investors flee. The latter case has the potential for quick returns, but also comes with greater risk, since it can be challenging to distinguish between a company just suffering a flesh wound and one on its deathbed.
But if you're able to identify the survivors from a crisis, the profits can be huge. Consider the last big banking crisis, the Savings & Loan crisis of the late 1980s. Quite a few banks went under. But the survivors have prospered. Citigroup (NYSE:C) has fallen dramatically in the past month, but in the 1990s following the S&L crisis, its compound annual returns were about 33%. Wells Fargo (NYSE:WFC) returned 23% and Fifth Third Bancorp (NASDAQ:FITB) returned 30% annually during that decade.
The difficulty, though, is determining who will survive and prosper. With that goal in mind, here are some of the issues I consider when trying to profit from panic.
Liquidity
In a crisis, cash gives a company the time and flexibility to survive a rough patch and reorganize its business. It's critical to get a good feeling for the degree to which cash on the balance sheet and future cash inflows are able to cover future cash outflows. Of course, the event causing the crisis often reduces operating cash flows, so using historical cash flow numbers can be deceptive. Instead, start with historical numbers and come up with a pessimistic approximation of the extent to which the negative event will impact cash flows, and how much cash outflows can be reduced over the short term through, say, delaying capital expenditures. If the company is close to the edge, there's a good chance it will topple over. In that case, avoid it.
Even if cash flow looks good, another liquidity issue to consider is debt. Even if it seems clear to shareholders that the company has enough cash flow to survive, lenders can be skittish. So it's a good idea to examine absolute levels of debt and future debt maturities. If the company is highly leveraged, or a substantial portion of its debt is coming due in the next few years, then the company may be unable to roll that debt over to future maturities. Often, it's not the slow draining of cash resources that leads to bankruptcy, but rather a large debt maturity that the company is unable to repay.
For instance, there were fears that NovaStar Financial (NYSE:NFI) would have to declare bankruptcy if it was unable to extend a net worth waiver and would be unable to pay back $83.9 million that it owes to Wachovia (NYSE:WB). It was announced this week that NovaStar received the financing waiver from Wachovia, but had it gone the other way, the company would've been in dire straits.
Asset strength
When it comes to turnarounds, the balance sheet can count more than the income statement. I've already talked about debt. Another factor to consider is the strength of the assets, because all assets are not equal. Cash is the best asset, since it gives maximum flexibility. Other good assets include securities and non-depreciating physical assets that can potentially be sold, such as real estate.
There are also bad assets that generally cannot easily be sold or generate cash. Such assets include goodwill and tax assets. Goodwill is useless because it's intangible, while tax assets can only be converted into cash when the company has operating profits -- something scarce during a crisis. So when considering a company's survival prospects, it's best to heavily discount the value of these assets.
The competitive position
Preferably, we buy a beaten-down company not just for its assets but also for its future operating performance. Ideally, the company is suffering from temporary bad news, but its long-term competitive position is intact. Maybe the company will show poor results for a year or two but is likely to prosper after that time. Perhaps the company has suffered a permanent setback but is still strong enough to be a viable business.
Bringing it together
A good example of all these issues is National Health Investors, a real estate investment trust that primarily owns nursing homes. National Heath was flying along quite happily when it hit the perfect storm. The Balanced Budget Act of 1997 cut Medicare revenues to its nursing home operators, the companies that lease National Health's buildings. Many operators went bankrupt. Plus, overbuilding, labor shortages, and lawsuits in Florida all hurt the company's prospects.
Confronted with these challenges, National Health collapsed like Mr. Bean sparring with Evander Holyfield. I became interested, and bought shares at $15. This was a wee bit early, since it cratered below $5 when the company discontinued its dividend only six months later. But this wasn't a technology company. It had solid real estate assets in a time of falling interest rates. Cash flow was still positive. The entire industry was unlikely to vanish: Somehow, someone would take care of the elderly. So I bought more at $5, and it started to look like the industry was recovering.
But National Health owed money to the banks. And the banks panicked, demanding repayment. So National Health was forced to sell convertible preferred shares at a time when the stock was low, diluting existing shareholders. I bought more in the $6 range. Cash flow was still good, nursing home operators were coming out of bankruptcy, and the balance sheet -- never really overleveraged to begin with -- now looked quite clean. It was difficult to see how National Health could fail.
Now, five years later, the stock is trading around $30. That's lower than it would be if it hadn't been forced to issue the convertible, but it's still a decent return. For months, value investors bought in the $5 range, and those investors have seen a 500% return. What's more, since National Health has a $2.00 dividend, investors at $6 are now seeing an annual dividend of 33% on their original investment. I sold out at $22.
The key points in this case were that cash flow was positive, leverage was reasonable, the assets were strong, and there were signs that the industry would turn around. Even then, the debt maturity hurt shareholders significantly, because nobody wanted to lend to companies in the sector. This is why, when analyzing turnaround situations, it is critical to consider debt maturities.
The Foolish bottom line
Evaluating these factors can help you find and identify turnaround plays that lead to extraordinary profits. For instance, in 2002, both Philip Durell, chief analyst of Motley Fool Inside Value, and I independently recognized that Providian Financial had a decent chance of rebounding. I bought at about $4, while Philip bought for $2 and change. Washington Mutual (NYSE:WM) acquired the company a couple years later at about $20.
This market is starting to offer similar opportunities. If you want to learn about what Philip sees as the great value plays right now and read all of his recommendations, a free 30-day trial to Inside Value is available.
This article was originally published on March 11, 2005. It has been updated.
Richard Gibbons, a juggler, thumb-fighter, and member of the Inside Value team, does not own any of the stocks discussed in this article. Washington Mutual is a Motley Fool Income Investor recommendation. The Motley Fool is investors writing for investors.
