Overlooked Stocks

by Geoff Gannon

In our most recent podcast episode, Andrew and I talked about “overlooked” stocks. I said overlooked stocks were basically synonymous with “oddball” stocks. You can read the Oddball Stocks blog here. I recommend going through every past post there and writing down the names of the stocks covered. It will give you a good list of stocks you might want to research and probably had never heard of before.

The truth, though, is that Oddball Stocks really only covers half of the universe I’d call overlooked stocks. The other half is “special situations”. The best blog to read for special situations is Clark Street Value.

Andrew and I also did a podcast episode about our favorite investing books. I mentioned in that episode – as I often have before – that Joel Greenblatt’s “You Can Be a Stock Market Genius” is my favorite investing book.

If you’re interested in overlooked stocks, I recommend reading both those blogs and that book.

Once you start thinking in terms of overlooked stocks – some otherwise odd stocks choices make sense. Among long-term readers and on-again-off-again readers of this blog: I get a lot of emails from two different types of value investors. One type is the Ben Graham / deep value / quantitative value investor. They remember me as someone who would buy a basket of Japanese net-nets, an OTC insurer trading below book value like Bancinsurance, and U.S. net-nets like George Risk (RSKIA). They ask me why my style changed such that I now invest in things like BWX Technologies (BWXT) that are so expensive and so clearly not value stocks. The other kind of value investor is the Warren Buffett / wide moat / qualitative value investor. They remember me as someone who would buy stocks like IMS Health (back in its previous incarnation as a public company). They ask me why my style changed such that I now invest in things like NACCO (NC) that is in a dying industry like coal.

The truth is that I tend to find the most success fishing in two ponds of stocks. One pond of stocks is what I’d call “overlooked”. These stocks are cheap because they are neglected. I should point out here that I don’t mean that all OTC stocks, illiquid stocks, stocks that don’t file with the SEC, stocks emerging from bankruptcy, spin-offs, the remaining company after a spin-off, etc. are in some sense either cheap or even necessarily neglected. Plenty of these stocks get plenty of attention. However, the argument that Keweenaw Land Association (KEWL) might be more likely to be neglected than General Electric (GE) makes sense. If GE sells for less than the sum of its parts, this should be for some reason other than a lot of people trading the stock aren’t bothering to do their own appraisal of each of the business units and then adding that appraisal together. In the case of GE, you could probably have a pretty efficient market in the stock even if 19 out of 20 buyers and sellers were traders dealing in the stock without any regard to the underlying business. If the other 5% of buyers and sellers were quite diligent business analyst types – the average stock price over any set of months could still incorporate a surprising amount of that information and analysis. Now, if all the trader types had the same sort of knee-jerk attitude about the stock – then you can easily drown out whatever useful analysis the investor types were doing. But, for an average stock in an average month – there’s a mix of optimists and pessimists both among investors and traders and it may all work out to a bunch of random noise.

The other pond of stocks is what I call the “contempt” group. A stock can be cheap enough, safe enough, and good enough that I could figure out it’s a bargain and yet others hadn’t already bid up the price a lot in two scenarios: 1) People haven’t looked at the stock and 2) People have looked at the stock – but, can’t get past their emotions and down to the logical part of their thinking.

I recently had coffee with a hedge fund manager when we got on the subject of whether you could apply the same sort of ideas you do in a personal account, a $100 million value fund, etc. in a $1 billion or $5 billion value fund. There are some very smart investors running funds those sizes on the same principles that value investors run much smaller funds. But, can it really work? Or do people who have success in big stocks need to use different strategies than what works with most stocks (that is, the small ones). We talked a little about our personal experiences – times when we really felt we found a stock trading well over a $1 billion market capitalization that looked as cheap as the stocks we find in the under $100 million market cap group.

I’ve had some good experiences in stocks with a market cap over $1 billion. An old example is IMS Health in 2009. It was eventually bought out. My results in IMS Health – an over $1 billion market cap stock – and Bancinsurance (an under $100 million market cap stock) were pretty similar. And, honestly, I’d group the two stocks together in terms of degree and especially clarity of cheapness. These were clearly stocks trading at less than two-thirds of a conservative estimate of their intrinsic value. There is a difference though. Bancinsurance was in a niche business, it was an illiquid stock, it had de-listed and traded over-the-counter (OTC) for a couple years, and then – finally – a controlling shareholder had made an offer to acquire the whole company. It was already pretty neglected before the offer. But, once a controlling shareholder makes an offer to buy out a company – many investors drop any attempt at analysis right then. The stock goes in the special situations / arbitrage category and no investors who don’t specialize in that area bother analyzing whether the stock is cheap, etc. It gets neglected.

IMS Health was not neglected. Investors were avoiding stocks generally (in early 2009), that area of stocks (healthcare stocks in the run-up to Obamacare), and to some extent IMS Health specifically (there was a Senator or two pushing for bills that were aimed at gutting a lot of what the company’s core business was). That kind of situation – a cheap moment in time, for an otherwise good business – is what’s worked for me with big stocks. Frost (CFR) is a big stock. And if you look at a stock chart to see where I bought all my shares – it was just a blip in time. It wasn’t long at all. People still thought the Fed Funds Rate might stay lower for a while. The increases weren’t quite here yet. And then oil prices had plummeted. Frost is 100% in Texas. And something like 15% of loans were to energy producers (in Texas). So, that worried some people. But, it obviously worried them very, very briefly. The stock wasn’t available that cheaply for long. This is typical of what I’ve seen with big stocks that get as cheap as small stocks often get. They don’t stay cheap for long. And their cheapness is very, very dependent on crowd psychology rather than a lack of interest from investors. It’s not that common for investors to continually overlook, misjudge, etc. a big stock quarter after quarter and year after year. That kind of thing is much more likely in small stocks. In big stocks, as soon as the cloud of fear or greed or whatever clears – the stock rockets upwards or plummets downwards or whatever the appropriate direction is.

Then there are overlooked big stocks. And the only stock I’ve owned recently – I actually still own it – that falls in this category is BWX Technologies. I’ve told this story many times. But, basically, when Quan and I found Babcock & Wilcox (which BWX was then a part of) we were immediately excited by what seemed to be a great, wide-moat business that was part of a public company trading at a normal price. Babcock itself had been spun-off from another company several years before. It had 3 parts. One was a speculative, money losing unit. It was essentially an experimental technology. We expected it to be closed down at some point or at least to be scaled down. Then there was a definitely cyclical and probably declining business (the present-day Babcock & Wilcox Enterprises). And the last part was BWX Technologies – the business we really liked.

I bought ahead of the spin-off. This was a mistake for two reasons. One, you really didn’t have to. You could’ve just bought when the spin-off happened and gotten a similar price on the piece you wanted. And, two, buying ahead of time encouraged me to size the position too small. Normally, I’d make a position 20% to 25% of my portfolio. I did the same thing in this case. But, then when the spin-off happened – the portion of my investment left in BWX Technologies (as opposed to the other newly independent stock) was in the 10% to 15% range instead of 20% to 25% range. I didn’t add more after the spin-off. That was my mistake. But, there are plenty of times where waiting till the actual spin-off can be unhelpful in terms of price. So, I wouldn’t say as a rule you should always wait till spin-off day.

My point with Babcock though is that when people email me about the stock they remember it was a spin-off, that I like Joel Greenblatt’s book “You Can Be a Stock Market Genius”, etc. and assume I bought it because I’m interested in spin-offs.

I bought the stock because it had a wide moat, predictable business in it and yet it was trading at what looked to be a normal price overall. I’d say the pre-spin Babcock was a neglected stock.

A good present-day examples of this sort of thing is KLX (KLXI). This one is a little different for a few reasons. One, Boeing (BA) has said it will buy the aerospace part of the business for $63 in cash. And two, the aerospace business isn’t actually being sold cheap. But, it’s similar to Babcock in that KLXI as a whole was a spin-off from B/E Aerospace. And then when I analyzed KLXI a couple years back, the thing that bothered some investors was the energy business. Well, if all goes to plan – KLX’s aerospace business will convert into cash (provided by Boeing) and the energy business will be its own standalone business. The difference here, of course – is that some people may say Boeing is getting the good business and people who buy KLXI stock today are getting the promise of cash from Boeing and the bad business. Maybe. But, it’s similar to Babcock in the sense that there are some issues of mixing businesses investors do and don’t want together, breaking things up, etc. It’s possible that investors neglected KLXI stock in the past because it mixed an aerospace business and an energy business. Investors won’t overlook the stock once the energy business trades on its own for a while. This is no guarantee the energy business is a good business. It is, however, a guarantee that the energy business will not be overlooked anymore.

This brings us to one of the two things that come up a lot with the special situations side of overlooked stocks.

One of the issues is the idea of a catalyst.

The obvious catalyst is that something that was overlooked won’t be anymore. This is even something I’ve said with a stock I own called NACCO. I’ve said that I wouldn’t be surprised if the business wasn’t well understood, the stock got less liquid over time, etc. for a year or more. But, eventually, a company puts out annual reports and does presentations and so on about the business. Some investors learn about it and post write-ups places describing the business model. Eventually, if some enterprising investors feel there is money to be made in learning about the business model, buying the stock, etc. word will get out. This is basically the classic question posed to Ben Graham about what makes a stock go up? Do you advertise or something? There are incentives for people to find a mispriced stock. It’s harder to overlook something that is now standing alone as just one business unit. It may take time. But, just being less overlooked is catalyst enough for a really cheap stock.

The final issue is the riskiness of these special situation overlooked stocks. Some are definitely quite risky. Greenblatt obviously invested in some really risky ones and benefited from the years he was operating Gotham – just as you have undoubtedly benefited from some risks you maybe shouldn’t have taken these past 9 years. Falling stock multiples, rising interest rates, recessions, etc. can kill stocks with too much leverage – both operating leverage and financial leverage. And investors who buy warrants, LEAPs, etc. are even more leveraged than that. So, yes, some special situation type overlooked stocks can be quite risky.

A really good recent write-up at Focused Compounding is one about Entercom (ETM). This is the minnow that swallowed the whale that is CBS Radio. It’s now the second biggest owner of radio stations in the U.S.

A lot of people have asked me about this stock’s margin of safety. And, honestly, while I think it’s a good stock – I don’t think it has a margin of safety. Allegedly, KLXI’s energy business is going to be the opposite of this. They’ve said it’ll be spun-off with $50 million of cash and no debt. Add to that the fact that they had recently been in a really bad part of the cycle in their industry – and there’s a nice margin of safety. They have cash. They don’t have debt. And you’d expect things should be a bit better this year and the next – not a bit worse.

My point here is that I’d definitely classify both Entercom and KLX as overlooked stocks. Entercom is mostly CBS Radio and it’s mostly held by shareholders of CBS who opted in to taking shares of the radio business. I’m guessing that outside of the people who actually run the company and the company itself (both insiders and the company have been buying Entercom shares lately) the people trading this stock are either shorting it or are special situations types not long-term investors. The situation at KLXI is also unlikely to attract long-term investors. In the case of both Entercom and KLX people are now likely to think of the stocks more as pieces of paper to trade and less as long-term ownership of a business to hold. Whether that qualifies the stocks as overlooked or not generally I don’t know. But, as long as the people – basically value investors willing to hold for a while – who think like me aren’t yet attracted to these stocks, I’m more likely to give them a closer look.

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