For the past four columns, I've been building boxes for stocks to fit into. I've called these boxes price momentum, growth at a reasonable price, or GARP, earnings momentum and value. Each is more commonly known as an investing style. I've measured individual stocks against the boxes to see which fit and which didn't, and searched for the ideal stocks for each box --
for the earnings-momentum box and
for the price-momentum box, to cite two examples.
But what about stocks that don't fit in a box? What should an investor do with those?
Most of the time, the best thing to do with such a stock is to forget about it. The fact that it isn't a good fit with an established investing style is usually a warning flag that should keep you from buying or owning the misfit. Occasionally, however, if a stock won't fit neatly in a box, it's a sign of problems with the investor and not with the stock. The investor is trying to apply an inappropriate investing style to a stock, and it's time to turn the whole analysis on its head. Even more infrequently -- so infrequently that the word "rarely" might apply -- the fact that a stock won't slide neatly into a box is an indicator that you've found something special, a stock that deserves a handcrafted, one-of-a-kind style of analysis. "Special situations" like these don't come along very often, but they can be extremely profitable.
So how do you tell these stocks apart -- the stock to avoid vs. the attractive stock that needs a new point of view vs. a special situation? That's the topic of this column. And I'll end by discussing five of the most interesting special situations in the current market.
Screens as a Reality Check
As I said, most of the time the reason a stock doesn't fit a specific investment style very well is simply because it's not a very good investment.
Let's say you've been watching the retail sector as it has been pounded recently. Must be some pretty good bargains there, you figure, so you run my simple value-on-price screen. The screen picks up
, but none of the retail favorites that you've been waiting to glom onto for months. What about
, for example? Shouldn't that stock be on this list?
You can be pretty sure that you're headed for investment disaster when you start to use "shouldn't" and "should" in this way. "Shouldn't" doesn't have anything to do with it -- Target simply isn't on this list, no matter what your preconceptions about the "value" created by the stock's steep plunge over the last month. (Running a screen like this is valuable precisely because it provides a reality check on your ideas of how the market should be.)
This value-on-price screen is so simple that it's very clear why Target hasn't made the cut. When I ran the screen after the close of trading on Sept. 5, the stock was certainly cheap enough. At $25 a share, it was within 20% of its 52-week low, as the screen requires. But the stock doesn't have any positive price momentum over the last month -- the other element of the screen. For August, Target fell 20%.
Why do we care about that? It's a good indicator that the stock could well be headed lower in the short term. The recent problems with Target's stock result from its warning that third-quarter earnings could come in below the 26 cents a share that it earned in the same quarter in 1999. With analysts projecting 28 cents a share before the warning, you can see why the announcement knocked the stuffing out of the price. At the same time, Target also lowered confidence in its previously announced goal of 15% earnings growth for the full year. Although the company didn't go into detail, the carefully hedged guidance on earnings growth for 2000 certainly raised the odds that investors could see more earnings warnings from the company before the year is out.
When Rethinking a Stock Pays Off
In Target's case, the fact that the stock doesn't fit the value-investing style means that it's simply not a very good investment. But that's not always the case. Take a look at
, for example. Here's a case where rethinking your analysis of a stock can pay off.
Maybe Commerce One showed up on your radar screen because you noticed that the stock was way off its 52-week high of $165, and that it had finally started to move off the bottom it had hugged for most of the summer. Sounds like a prime candidate for the value-on-price screen.
But Commerce One doesn't make that list. Turns out you've waited too long, and the stock has moved up by more than 50% from its July lows near $40 to trade at $65.88 on Sept. 6. This isn't a value stock any longer.
True enough, but value wasn't ever a particularly good fit for Commerce One. The stock's price-to-sales ratio is almost 90 and its price-to-book ratio is almost 20. Remember that when I built my value-on-sales screen, I was looking for a price-to-sales ratio of 2 or less. With my value-on-book screen, I was looking for a price-to-book-value ratio of 1 or less.
When a stock fits a style box as poorly as Commerce One fits the value box, I think it's always worth taking a look to see if it better fits another box. If I run the price-momentum search that I adapted from one of
screens for my column
"How to Find Mighty Mo in an Otherwise Meek Market," Commerce One turns up in the top 15 results. This isn't a failed value stock; it's a very solid price-momentum pick. And it fits very easily into that investment style.
A special-situation stock, by contrast, poses an analytical problem that can't be solved simply by switching from one investing style to another. These stocks don't fit in any box very well, if at all.
Take a look at
, one of the special-situation stocks among Jubak's Picks. The stock hasn't been climbing fast enough over the last year to qualify for the price-momentum list, even though Icos climbed 33% in the last quarter. The company doesn't yet have any earnings, so it belongs on neither the GARP nor the earnings-momentum screens. And with a price-to-sales ratio of nearly 40 and a price-to-book ratio of just about 30, Icos certainly isn't a value stock.
But despite the fact that this stock doesn't fit into any of the investing-style boxes -- or maybe, because it doesn't -- I still think it's a buy right now. Something very special is going on at the company that isn't captured by any past or current numbers. Sometime next year, Icos and marketing partner
will go to the
Food and Drug Administration
to ask for approval to market Cialis, a competitor to Viagra. Assuming that drug is approved, Icos will go from being a company with no product sales and only $70 million in total revenue to a company that owns a major part of a drug that will rack up annual sales of somewhere between $500 million and $1.5 billion when it hits full stride. It's that situation -- and not the current numbers on earnings or sales or price momentum -- that will drive the price of Icos stock higher over the next year, in my opinion.
Five Haystacks Worth Searching
Finding special-situation stocks isn't easy. You certainly can't screen for them. Past numbers usually fail to capture whatever situation is likely to drive the stock price up over coming months. And special situations vary so much from one to the other that each has to be pretty much analyzed independently.
Still, searching for special situations isn't quite like looking for a needle in a field full of haystacks. It's at least possible to say which haystacks are most likely to reward an investor's search. Here are five places to look and five special situations that I think are likely to pay off.
- Companies tarred with accounting improprieties and scandal. Nothing like a whiff of scandal to make investors overlook the value of a company's business. Look at
Cendant (CD) , for example. In April 1998, the company, formed by a merger of HFS Inc. and CUC International, discovered massive problems with CUC's books. The day after the announcement, the stock fell nearly 60% -- wiping out about $15 billion in market capitalization. Not surprisingly, the company wound up facing more than 70 class-action lawsuits. Cendant took a one-time pretax charge of $2.8 billion at the end of 1999 to account for the cost of settling the suits and it will begin making payments in the third quarter of this year (and go on making them for the next two to three years). But even though the courts have now set the amount of the settlement and it's clear the company will have enough cash to pay the tab, the stock has been stuck below $16 since April. It's now trading at just about 12 times the consensus analyst earnings estimate of $1.10 a share -- that's about 60% of the 20.3 multiple (on estimated 2001 earnings per share) currently shown by
Standard & Poor's 500 index. The company's No. 1 market position in residential real estate services and hotels -- plus the potential for online marketing -- attracted a $400 million investment from John Malone's
Liberty Media (LMG.A) last year.
- Companies with confused or complex ownership structures. As part of the settlement between
AT&T (T) - Get AT&T Inc. Report and
Excite@Home (ATHM) - Get Autohome, Inc. Sponsored ADR Class A Report on one side and Excite@Home shareholder
Cablevision Systems (CVC) on the other, the cable operators who own parts of Excite@Home got the right to sell their Excite@Home stock to AT&T for a minimum of $48 a share starting next Jan. 1. Not a bad price, considering that the stock now goes for about $17.50. A discounted flow analysis done by Prudential Securities -- a reasonable way to value a company that isn't likely to make a profit any time soon -- values Excite@Home at $80 a share. Whichever of these figures you start with, it seems that the current price is a huge discount that needs explaining. My explanation starts and ends with the ownership structure of the company. AT&T wanted control, so it was willing to promise the cable companies a premium. The stock isn't worth $48 to anyone but AT&T, the market is saying. As for the $80 value from discounted cash flow, forget about it, too, since this company still has too many conflicts of interest and divisions in management to conquer the market. And the market seems to be saying that AT&T clearly can be counted on to blow it. Could be, of course. But the size of the discount seems extreme to me, even given AT&T's recent track record. Excite@Home is one of only two nationwide Internet-over-cable service providers. And now that AT&T has gained 74% voting control, I think that company's self-interest clearly runs in the same direction as Excite@Home shareholders'.
- Companies that own an asset everyone hates. If only
Loral Space and Communications (LOR) - Get Lazard World Dividend & Income Fund Inc Report didn't own 40% of
Globalstar Telecommunications (GSTRF) . In the second quarter, revenue from fixed-satellite services grew by 24% compared with the same quarter in 1999, and revenue from data services grew by 64%. Net bookings increased by $196 million, and backlog for the year was up 44%. But nobody knows exactly how much Loral is on the hook for Globalstar. Management has told analysts that it is working on a plan that will explain how the Globalstar build-out will be funded and what it will cost Loral. Analysts are currently guessing that the stock should be worth somewhere between $6 and $9, given what they know of Loral's commitments to Globalstar. At the Sept. 6 closing price of $7.69, that would make Loral either 22% overvalued or 17% undervalued. But if Loral's management could come up with a plan to fund Globalstar that drew more on the public markets and less on Loral, Loral's stock could be worth $10 to $13 a share on the strength of its own business. If Loral did not have to fulfill its $500 million loan guarantee to Globalstar, and the company managed to get back most of its $300 million in vendor financing, analysts estimate that Loral could be worth as much as $14 a share. And, of course, if Globalstar actually became a success, Loral's stock would be worth much more than $14. Right now, though, no one has enough information to evaluate this situation, which is why the stock is going at this writing for under $8.
- Companies living under a news cloud. From the news stories lately, you'd think the deal between
America Online (AOL) and
Time Warner (TWX) was in deep trouble. The
Federal Trade Commission, the stories report, is going to insist on open access to the companies' Internet pipelines. That's exactly what everyone has expected all along, and all along the question has been what form such guarantees are going to take and how they might work. But news stories -- even if they're pretty much what everyone expected -- heighten anxiety and raise uncertainty. Deals do get killed. So stocks that live under news clouds trade at lower prices. It's as simple as that. And of course, when the news clouds get lifted, the stocks move higher.
- Companies with big earnings or sales bonanzas on the horizon. That's exactly the situation that I described above for Icos, but Icos is not the only stock -- not even the only biotech -- that's looking at a big payoff not too far down the road.
Genentech (DNA) , for example, has submitted Xolair, a drug for the treatment of asthma, to the Food and Drug Administration. Tests have shown that Xolair can reduce asthma attacks by 50%. With an estimated 17 million Americans suffering from asthma, the drug clearly has blockbuster potential. Right now, it looks as if the drug is on track for approval in the first half of 2001.
I've offered these special situations as examples of how to look outside the box and what you might find. (And I think several of them -- Icos, Genentech, Excite@Home and Cendant -- are worth some due diligence on your part.) With this column, I've finished my review of major investing styles -- inside and outside the box -- and I'll now be going back to my regularly scheduled programming.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: America Online, Commerce One, Global Crossing and Icos. He welcomes your feedback at
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