With the market falling in the past couple of years and the selling having picked up on a few occasions this month, it's a good time to ask again what makes a value stock a value stock.
In a market like this it's tempting to look at any big name that's fallen a lot and say there's value there. For almost any given stock, you can name a metric that will show the stock looking cheap. But it's by buying good stocks at a low price that value investors make their money.
Let me be clear: The line between a stock that's a good value -- one with a good business whose true worth is being underestimated by the market, for whatever reason -- and a cheap stock with few prospects of a rebound can be a tough one to draw. So let me offer you a couple of case studies that will show how I separate the wheat from the chaff.
By doing this I think you'll be able to get into my mind and better understand not only what characteristics I look for in a value play, but also the specific catalysts I need to see before I pull the trigger on any given stock.
Let's look first at
, which on the surface appears to be a terrific value play. At around $5, it sports more than $3.70 a share in cash and trades at just 1.3 times book value. It has no long-term debt to speak of and management is cutting costs, trying to swing back into the black next year.
That said, investors should keep in mind that the company's ability to cut costs is seriously constrained by the roughly 275 retail locations it maintains throughout the U.S. This is a serious disadvantage, considering that the company is competing head-to-head in the consumer market with low-cost leader
, which sells hardware over the Internet.
A bigger problem -- and one that can't be measured in absolute dollars and cents -- is the company's merchandise mix. Most of Gateway's revenue comes from the PC business, where prices dropped 17% over the last year, by the company's count. The way around this is to sell products that go beyond the box, as the saying goes. But at this point only about 18% of revenue comes from digital merchandise and the like.
Then there is the issue of market share. Gateway's market share is at 7% and dropping, as Dell continues to suck share away from its competitors. And in recent years Gateway has been focusing on cutting costs rather than building new and exciting products. That's a good way to cut overhead, but it won't help you draw new customers, which is what Gateway needs to do.
In sum, the stock is likely to remain in the doghouse until Gateway can figure out how to start growing again.
Now for a look at
. Like Gateway, the company's numbers look intriguing at first: Xerox trades at around $8 and holds something like $5 a share in cash on its balance sheet. With the stock trading at under two times book value, it's easy to see why some investors find the stock so appealing. But there are some other problems with this story.
The first problem for the Xerox investor is probably the market's big problem right now, too -- debt. Xerox's debt load was more than $13.4 billion at last count, and trying to trim that through asset sales isn't cutting the mustard. As evidence, S&P recently cut its credit rating on the company and placed it on credit watch with negative implications. Not a good sign.
Another red flag is that the company is in the process of restating earnings after it improperly booked revenues over four years. It's hard to keep track of how a company's operating if you can't trust the numbers.
Most of all, Xerox suffers from the same illness as Gateway -- a stagnant top line. The company has spent so much of its time trying to improve its liquidity (through more than $2 billion in noncore assets sales), that it hasn't spent enough time building new products.
As a result, investors watching Xerox will need to see two things happen: First, they'll need to see updated financials to get a better handle on the company's ability to service its debt. Second, it would be nice to see Xerox roll out a strong new product to revive growth. Absent these two catalysts, I'd say there's a good chance that Xerox could stay cheap for a while.
Bottom line: When it comes to value investing, you get what you pay for.
In keeping with TSC's editorial policy, Glenn Curtis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Curtis welcomes your