How to Trade Bad Management

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As a sell-side analyst in recent years, I followed L-1 Identity Solutions ( ID), which is involved in a range of ID programs from driver's licenses to facial recognition software. Trouble is, management simply couldn't resist the urge to promise too much. They were one of a number of management teams that had built a reputation for "overpromising and underdelivering."

So what do you do if you like the business but can't believe management? Sit and wait. In time, you can acquire stock in such a company at a greatly reduced price, usually when most others have thrown in the towel.

My colleague Steve Gear wrote a comprehensive review of the company's virtues a few weeks ago. I don't quibble with Gear's analysis and agree with him that the stock holds great appeal now that it trades below $4. I'm just glad he didn't recommend the stock when it was at $10 last year, $20 in 2007 or $30 back in 2004.

In the span of the last five years, L-1's CEO Robert LaPenta serially offered quarterly guidance that was simply unobtainable if you bothered to do the math. For many of us, it came as no surprise when he would suggest the next quarter that "we missed our targets last time for reasons beyond our control, but we'll blow away our targets this time."

And therein rests the most important step an investor can take: refraining from buying an appealing stock. Instead, listen to management's goals on the conference call and then listen again the next quarter to see if they delivered what they promised.

If they "underpromise and overdeliver" for several quarters in a row, then it's time to buy the stock. Conversely, constantly missed targets signal that you should avoid the stock or even short it.

Make no mistake: L1 Identity Solutions has a wide range of solid, repeatable contracts that should generate the cash flow that now makes the stock look much more attractive -- even if management drops the ball yet again. If I were still a sell-side analyst, I'd finally be inclined to recommend this stock.

A host of other companies fit into the category of "good prospects/untrustworthy management/appealing valuation." One that comes to mind is Zoltek ( ZOLT), which makes carbon fiber for a range of industrial applications.

Carbon fiber, due to its light weight and high strength, has generated so much buzz that Zoltek decided to sharply boost production. Trying to expand capacity while keeping in the sweet spot of pricing and demand is tricky for any young business. But Zoltek's founder, Zsolt Rumy, hardly inspired confidence in the investment community, as every quarter was a combination of missed targets and promises to do better.

My colleague Larsen Kusick (author of TheStreet.com's Breakout Stocks ) was wise enough to dump the stock from his portfolio when it fell to $25.

"Regardless of the growth story or how good results may be, large institutions are rarely willing to apply a high valuation to a company that has a weak or untrustworthy management team," he notes.

Brian Yerger, who used to follow the stock for Jesup & Lamont, concurs. "When quarter-to-quarter missteps are brushed aside as one-time issues,but keep happening over and over again, credibility in what he says is lower or lost altogether."

From Kusick's perspective, "there are enough stocks out there that you don't have to own the ones where you have to admit that management has blemishes on its record."

He's right -- to a point. Although management has lost its credibility with investors, the carbon fiber industry still holds great long-term appeal, and the company's stock is now more than 75% below the point where Larsen dumped it from his portfolio.

Larsen suggests that Hexcel ( HXL) is a better play on carbon fiber, but in some respects, Zoltek still holds great appeal. Much of its manufacturing capacity is in lower cost sites such as Hungary and Mexico, which has yielded gross margins roughly 500 basis points higher than Hexcel. Moreover, Zoltek is in a net cash position, while Hexcel is carrying more than $300 million in net debt -- a key consideration in a prolonged economic downturn.

Clearly, both firms would sharply benefit from a return to global economic growth as carbon fiber is still seeing demand for new applications, such as in Boeing ( BA) and Airbus' newest advanced plane fuselages, brakes and wind turbines.

Another item that causes investors to flee is executive compensation. For example, Broadcom ( BRCM) is notorious for excessive management compensation, which has put its stock on many institutional "do not own" lists.

I personally find excessive management compensation to be appalling, but I can't lose focus of the fact that Broadcom is positioned to profit from many of the still-evolving communication technologies. So I'd be a buyer of the stock and hold my nose on management. At least Broadcom has hit many of its operating targets in recent years, unlike Zoltek or L1 Identity.

I'd like to hear from you: Are there any stocks you know about that trade at a sharp discount to intrinsic value due to untrustworthy or greedy management?

Please note that due to factors including low market capitalization and/or insufficient public float, we consider Zoltek and L-1 to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.


Know What You Own: Sterman mentions L-1 Identity Services; similar security and protection services companies include Brinks (BCO), Geo Group (GEO) and Checkpoint Systems (CKP). For more on the value of knowing what you own, visit TheStreet.com's Investing A-to-Z section.

This was originally published on RealMoney on March 12, 2009. For more information about subscribing to RealMoney, please click here.


How do you survive -- and even prosper -- in a rocky midyear market? Get the "best ideas to make real money" from Jim Cramer, Doug Kass, Helene Meisler and other RealMoney experts at our May 2 Investment Conference. Learn more here.
David Sterman has been an equity analyst and financial journalist for 15 years, most recently serving as Director of Research at Jesup & Lamont Securities.

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