Markets
Profit From Uncertainty
Just because a company's future is highly uncertain doesn't mean it's a risky investment.
By Whitney Tilson, Contributing Editor
John Heins, Contributing Editor
From Kiplinger's Personal Finance magazine, January 2009
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October was an extraordinary month for the markets. It was the worst month for Standard & Poor's 500-stock index in 21 years and the most volatile in the entire 80-year history of the index, moving 4% or more on nine days (four up and five down).
To get a sense of how unusual that is, consider that in the five years from 2003 through 2007, there was not a single day in which the S&P 500 moved as much as 4%, and there were a total of only five such days in the two decades of the 1950s and 1960s.
The volatility was even more extreme in many international markets, including those in Russia, Britain, Japan, India and Brazil, underscoring how intertwined world markets and the financial system have become.
There are two potential silver linings to this unprecedented volatility, one possible and one quite likely. First, the extreme volatility may signal a market bottom. For example, according to the New York Times, the biggest post-World War II weekly increase in the S&P 500 was a 14.1% jump during the week ending October 11, 1974, which came at the end of the 1973-74 bear market. In addition, the biggest week in the 1980s, a gain of 8.8%, came just after prices hit bottom in August 1982.
The second silver lining? Regardless of whether we saw a market bottom in October, the recent investor panic and resulting volatility has created a great many exceptional investment opportunities. That's not at all to say everything is cheap and you can throw darts at a stock page and be successful. But we're confident that selective bargain hunting today will pay off handsomely in the future.
The best opportunities fall in three broad categories: moderately undervalued blue chips, deeply undervalued and out-of-favor blue chips, and extremely undervalued companies with small and midsize market capitalizations.
Battered but unbowed
In any market characterized by panic selling, even the best companies can see their share prices fall much further than their long-term business values would warrant. As a result, such dominant companies as Berkshire Hathaway, McDonald's, Wal-Mart, Altria, Coca-Cola, Microsoft, ExxonMobil and Johnson & Johnson were all recently selling for at least 20% to 30% discounts to what we think they're worth.
On average, these eight stocks have held up relatively well, falling "only" 9% from the market's peak on October 9, 2007, compared with a 39% drop for the S&P 500 (all results are through November 7). Given the high quality of their businesses, each should trade at 18 to 20 times 2009 earnings estimates rather than the roughly 13 times at which they trade as a group. And while you wait for the stocks to appreciate, you'll receive an average dividend yield of 3%.
The second area of fertile opportunity includes equally impressive companies that have seen their share prices fall even further because they operate in particularly troubled sectors, such as retailing and financial services. We've previously written about our favorite ideas in this category, Target (symbol TGT) and American Express (AXP), and while neither has paid off yet, we believe that each trades at a significant discount to what it will be worth in two to three years.
American Express, for example, will no doubt incur unusually high losses in its credit-card business and will be hurt by weak consumer spending as the economy continues to falter. But nothing we can see on the horizon threatens Amex's long-term competitive position and enviable business model. It's exceedingly rare to see such a great business trade at a price-earnings ratio of less than 9.
And the outcasts
The final category of stocks we find particularly interesting is made up of small- and mid-cap companies whose shares, in many cases, have been hit by a double whammy: reduced earnings expectations and forced selling by hedge funds and others. This description certainly applies to the energy sector, where oil and natural-gas prices have fallen by roughly 50% since July, causing numerous stocks in the sector to plunge faster.
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