5 Places To Search For Hidden Profits
Value investing involves buying a business for substantially less than its intrinsic value. So what causes businesses to occasionally become available at such a large discount? Once in a while, the prevailing market mood is so pessimistic that you can look around and find many quality companies at low valuations based on readily apparent levels of profits. Such instances are rare. The rest of the time mis-pricings arise because of hidden profits – future profit levels that are reasonably predictable based on currently available information that are substantially higher than the current levels of profitability. If you know where to look, even in a market environment like the current one, with relatively few attractive opportunities, you stand a better chance of uncovering attractive bargains.
Beware of the Obviously Cheap Securities
You found a company that you think is at least decent. You check – and low and behold, the stock is trading at a very low valuation of its current profits. Should you be excited? Maybe.
Sure, it’s possible that you have found a hidden gem that is offering a very attractive implied rate of return based on its future cash flow stream. However, unless you are dealing with some neglected corner of the market (always a good place to look), don’t you think many market participants have looked at the same set of facts, have seen the low valuation that you have now observed relative to current profits and yet still set the price at this low level? Of course, there is always the chance that the market is wrong and that the current level of profits is sustainable, but there is also a chance that the market-implied view that future profits are likely to be lower than the current level of profitability is the right one. So unless your analysis convinces you that the stock is actually mis-priced based on the company’s reasonable future cash flow stream and not just statistically cheap, but correctly valued, based on its current, unsustainable, level of profits, you haven’t found a bargain.
Patterns of “Hidden” Profits
- Cyclical Businesses – Let’s suppose that there are no structural issues affecting the company, but the business is deeply cyclical. At the low point in the cycle, the company’s then-current profit levels will be far below their cycle-average levels. The best part? If you are right that the problems are purely cyclical, it’s just a matter of time until the cycle turns and the company achieves the level of profits you estimate it to be capable of in a more normal external environment. Yet, most market participants are unwilling to look out far enough when the current fundamentals aren’t pretty, and instead insist on trying to time the turn in the company’s performance. If you have, as I have suggested on many occasions, adopted the long-term approach to investing, you have a built-in advantage vs. many others whose temperament or incentives will not allow such an outlook.
- Turnarounds – Most turnarounds do not “turn.” It has been estimated that approximately 2/3rds of companies experiencing a company-specific decline in profitability fail to reach their previous level of results. While I typically do not advocate betting against the base-rate probabilities, there are cases when the turnaround has become more certain than not, and yet the financial results have not yet reflected this. The trick is to know what the key operating metrics are that are leading indicators that the company’s management has been able to right the ship. There are times when such metrics are moving strongly in the right direction, which greatly increases the odds of a successful turnaround, and yet the bottom line results have not yet caught up due to the timing of revenues and expenses. These are the ones that, if you can identify, are really “hiding in plain sight.”
- Bad Business/Good Business – Imagine a company with two divisions, A and B. Division A makes $2, Division B is losing $1, and the company overall is making $1 in profits. The market frequently values the company based on that aggregate level of profitability. What if management could, or more importantly was showing signs of selling, spinning off or shutting down Division B? Then, all of a sudden a company that not long ago was only making $1 is going to be making $2, and might look like quite a bargain at the original price before the market adjusts to the new reality.
- Good Businesses in Investment Mode – The best corporate managers don’t try to maximize short-term profits. Instead they try to maximize the very long-term profits. Frequently that might involve investments that are being expensed in the current period which will only bear fruit several years down the road. The result is that the current level of profits is not representative of the company’s true earnings power. Either these investments are going to get a good return and profit levels will rise, or management will realize that they are not being successful and eliminate the investment-related expenses. In either case, you have a situation with hidden earnings that many short-term oriented market participants are not likely to fully reflect in the stock price.
- Early Stage Proven Businesses – The key word here is “proven.” There are many early stage companies that think they will be making vast sums of money years down the road. Some will be right, but many will find the future to be more disappointing than their optimistic assumptions. So what makes a business “proven”? In this case, it is the presence of a durable competitive advantage that is already established in a market which is at an early stage on the penetration curve. Recent examples are “platform” companies with sustainable advantages based on the economies of networks. Once such a platform achieves dominance, it is very hard for others to compete (think eBay in U.S. auctions many years ago). Once you determine that the eventual size of the market is likely to be many times its current size, you have a high degree of likelihood that the company that you are studying is going to make a lot more money in the not too distant future than it is making now. This can create a situation where a very statistically expensive stock is substantially undervalued. Be careful with this last pattern – make sure that it is cold hard facts and analysis that are influencing your view, not hubris about your ability to predict the future. The number of companies that fit these parameters is small, so if you find yourself seeing one around every other corner, chances are you might be falling under the spell of optimistic management teams who are confusing what is possible with what is likely.
Conclusion
As a value investor, it’s tempting to power on your computer, search for companies trading at a low multiple of profits, and believe that the resulting list of companies is filled with genuine bargains. While some of these may undoubtedly be undervalued, such a list will also contain many broken businesses, companies in secularly declining industries as well as those that happened to produce a good year or two of profits in a way that is not representative of their future potential. A better place to look is companies with “hidden profits.” There are two criteria when searching for these companies:
- Current profits are unrepresentatively low relative to likely future results
- The higher future profits are reasonably predictable in advance based on currently available information
There are a number of “patterns” that create these opportunities, in most cases due to some form of short-termism by most market participants. So use your advantage as a long-term investor to its fullest – go beyond the “obvious” bargains to ones that are far more likely to result in success if you stay within your circle of competence. Happy bargain hunting!
Note: This article was contributed to ValueWalk.com by Gary Mishuris, CFA of Behavioral Value Investor.
Category: Investing in Penny Stocks
