Bad news involving large numbers just doesn't have the same effect that it used to.
When I see that small-cap restaurant Cracker Barrel has a debt balance north of $700 million, I think, "Don't you mean 'billion'?" When I see casino behemoth MGM Mirage's $14 billion debt balance, my first response is, "Oh, that's just a tiny bailout."
Even the Bernie Madoff scandal took awhile to really sink in. A year ago, stealing $50 billion would have really made an impression. The Ocean's 11 gang only took $150 million, after all. They'd have to do that more than 300 times to pull off a Madoff-sized heist.
But I'm not here to moralize. Instead, I'm here to point out the opportunities to profit.
Many of the negative headlines we read about have a flip side. The losers beget winners who seize the opportunity to grow fat on the remains.
Let's look at two of this year's notorious examples and then find out how to spot the winners.
Slumdog billionaire
When Indian IT outsourcer Satyam's fraud news broke earlier this year, there were definite winners and losers. Satyam is, of course, the loser. The winners were international behemoths Accenture (NYSE:ACN) and IBM (NYSE:IBM).
While other Indian outsourcers such as Wipro and Infosys (NASDAQ:INFY) benefit from the weakening of a direct competitor, they will likely suffer from the bad press and a lack of confidence in all Indian outsourcers. After all, in the business-to-business world, a sterling reputation and the unquestioned ability to deliver on long-term contracts are prerequisites to winning clients.
I don't think it was a coincidence that when I searched for "Satyam" on both Google and Yahoo! a few weeks after the scandal hit, I saw a sponsored link from Accenture. Same with a search for "Infosys." Their reputational pain was Accenture and IBM's gain.
But it's not just the Indian outsourcers who suffer. To a lesser extent, it's all publicly traded Indian companies. This wasn't an Enron situation with tricky off-balance-sheet derivatives -- Satyam claimed a billion dollars in nonexistent cash and bank loans. Verifying cash is so easy that it's the first assignment that auditing interns are given.
Accenture and IBM certainly won, but so will investors who are able to properly assess the risks and opportunities of investing in Indian companies.
Short-circuited city
Closer to home, a bad retail environment means consolidation. When Circuit City went bankrupt earlier this year, most of us made the logical assumption that Best Buy (NYSE:BBY) would be helped. But it wasn't quite that simple.
Discount retailers reacted by bolstering their electronics departments to capture some of that abandoned market share, even as all the bricks-and-mortar guys, including Best Buy, are fighting the steady onslaught of the online players, led by Amazon.com (NASDAQ:AMZN).
Yet even with multiple vultures picking at Circuit City's carcass, Best Buy is the biggest winner, because as Circuit City's most direct competitor, Best Buy is the logical replacement in the minds of its customers.
How to spot the winners
The direct winners are pretty obvious: Accenture, IBM, and Best Buy. Identifying winners is made easier when an accounting scandal hits or a company goes bankrupt.
But how do we identify winners who may be unfairly punished by market pessimism but are, underneath, healthy and able to take advantage of opportunities as other companies falter?
Here are three qualities the predictable winners will possess:
- Manageable net debt. Companies with little debt and lots of cash can survive periods when their cash flows dwindle and their access to credit is limited.
- Positive earnings leading to strong free cash flow. Now's a very dangerous time to be bleeding cash.
- Future earnings power. When companies are unfairly punished, their earnings are often depressed -- which means they're likely to rise when pessimism gives way to realism.
The companies that can weather the turbulence and feast on the misfortune of the losers can actually come out stronger on the other side. We win when the market prices them like the losers.
A recessionary winner
To be clear, the biggest winners out of this recession may be much riskier plays that don't share these qualities. For example, if the companies that teeter on bankruptcy recover, their short-term gains will dwarf the companies with healthy balance sheets, positive earnings, and good future prospects. But the latter companies also have a very high likelihood of being the losers that the winners profit from.
One example of a company meeting my three criteria is Motley Fool Inside Value recommendation Paychex (NYSE:PAYX). There haven't been any big payroll-processor scandals or flameouts (in fact, its most prominent competitor, ADP (NYSE:ADP), is quite strong), but its inherent strengths mean it's poised to pounce on any opportunities that come its way.
Both Paychex and ADP have been on my personal watch list for a while now as I stalk a more attractive price point. If you'd like to see all of the Paychex analysis by the Inside Value team, as well as their other recommendations, click here. A 30-day trial is free.
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Anand Chokkavelu owns shares of Accenture and Citigroup. He hasn't seen this much opportunity to profit from Scandal since Patty Smyth in the '80s. Google is a Motley Fool Rule Breakers selection. Amazon.com and Best Buy are Stock Advisor recommendations. Accenture, Best Buy, and Paychex are Inside Value picks. Paychex is an Income Investor recommendation. The Fool owns shares of Best Buy and has a disclosure policy.
