Treasure and Trash When Dumpster Diving for Stocks

NEW YORK (TheStreet) -- Buying distressed securities is one of the tools in the arsenal of value investors. We sometimes buy stocks that few other investors want: stocks that are downright ugly in many respects. The key here is to identify situations where, no matter how bad the situation may appear, the punishment inflicted on a stock by the market is beyond what is deserved.

This can be a risky game, and it's easy to make mistakes. It's also easy to fall into some bad investment habits. I've certainly made my share of miscues in this area. But when you are right, the rewards can be great.

This type of investing is much easier, for lack of a better word, when the markets are under tremendous stress as they were in 2008 and early 2009. The likes of Gannett (GCI), Saks (now owned by Hudson's Bay (HBC:Toronto)) and many others were priced for bankruptcy, and the rewards of buying those names were great. Others, such as Cabela's (CAB), and eBay (EBAY), were not truly in distress but were priced as though they were in big trouble. The rewards of buying them have been stellar.

It was an irrational market, and those that could get past the seemingly never ending freefall and daily doses of bad news were able to take advantage.

GCI Chart
GCI
data by YCharts

It's a much different environment today. The bargains are not plentiful, and there are a whole bunch of value investors who are bored because they can't find much to get excited about. One value manager told me recently that his firm is doing a lot more selling than buying.

With so little to be excited about in deep value land, it becomes easier to fall into the traps.

I read a piece yesterday that was focused on J.C. Penney (JCP), which essentially stated that because the stock had been beaten down so ferociously and was trading for such a "low" price, that it might be worth buying -- that it could easily double.

Be very careful following such lines of reasoning. There's a difference between being decimated by the markets due to irrational factors, and being decimated because your operating performance is horrible.

In some cases, such as J.C. Penney's, using low price-to-book multiples as another justification for cheapness is a bad idea.  Price-to-book multiples are sometimes meaningless, because book value continues to fall. It's a moving target, and where it stops, nobody knows.

JCP Chart
JCP
data by YCharts

Could J.C. Penney stage a turnaround? It could. Could shares be worth significantly more than the current $6 price tag? Quite possibly.

But trying to justify that the stock is cheap just because it has fallen into the mid-single digits is ridiculous.

The situation is somewhat reminiscent of my days writing for a major personal finance magazine in the early 2000s. We had a monthly feature called "My Favorite Stock," in which well-known market pros opined on their favorite name. Once, the editor presented the insurer Conseco (CNO) for the feature. I was shocked. Conseco was in deep trouble in my view, but the pro in question was both well-known and well respected. My objection was rejected. By the time the issue was released, some two months later, Conseco had filed for Chapter 11 bankruptcy. At the time, it was the third-largest bankruptcy in our history.

I am at times a "dumpster-diver." I love to find misunderstood, beaten down stocks that I believe are undervalued by the markets. But I can't justify taking a position in J.C. Penney at this point. There may be more dust to settle on this one, and a $6 price could easily turn into $3. It's bad enough that I own RadioShack (RSH).

At the time of publication, the author was long GCI and RSH, but held no positions in any of the other stocks mentioned.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

Jonathan Heller, CFA, CFP® is president of KEJ Financial Advisors, his fee-only financial planning company. Jon spent 17 years at Bloomberg Financial Markets, where he ran the equity research division and wrote and edited for the publishing division. In 2005, he joined SEI Investments as director of investment communications.

Jon is also the founder of the Cheap Stocks Web site, a site dedicated to deep-value investing. He attended Grove City College and has an MBA from Rider University, where he has also served on the adjunct faculty.

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