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That Stock is Dead Money

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March 19, 2011 – Comments (18) | RELATED TICKERS: D , EAD

I've heard that time and time again: that stock has done nothing over 10 years.  Why would you buy it? These arguments usually refer to many large cap tech stocks and other former amazing growth stories such as WMT.  I'll use WMT as my go-to example when I need one, but a ton of tech stocks and other names also apply.

1. Stocks fluctuate from undervalued to fairly valued to overvalued to fairly valued to...you get my point.

Each point in the cycle can last anywhere from weeks to months to many years.  Do you know what these stocks were 10 years ago? You guessed it: really, really overvalued.  In FY 2000, WMT earned $1.21 per diluted share on revenue of $165 billion.  In FY 2010, WMT earned $4.46 per diluted share on revenue of $422 billion.  Adjusting for dividends, WMT closed at $41.13 on March 19, 2001.  Without adjusting for dividends, WMT closed at $47.38 on March 19, 2000.  On March 18, 2011 (the 19th is Saturday, of course), WMT closed at $51.52.  

If you ask me, WMT was extremely expensive 10 years ago and is actually looking pretty reasonable today.  That gets me to my next point...

2. Price matters.  A lot.

Buy an overvalued stock and you lock in a higher cost basis forever.  The higher the price you pay, the lower your expected returns.  If you can pay a lower price, you will bump up those expected returns.  Buying WMT at $47.38 back then when it had only earned $1.21 per share the previous year? That's called overpaying.  The stock can still go up from there, but that's not such a great idea.  Paying 39 times earnings or some very high multiple of sales or EBITDA for a retailer? Bad idea. 

Buying WMT today is a different story, of course.  The stock's virtually gone nowhere and the company's managed to almost quadruple earnings per share.  Based on the current price, you even get a 2.8% annualized dividend to boot.  

3. Reward-to-risk ratio

Risk to me is lost money, not volatility.  Let's say you've done your homework and you have determined reasonable upside of 40% and reasonable downside of 20%.  Reward (40%) to risk (20%) is 2-to-1 here.  I'm quite aware that valuation work can be extremely wrong even if you've accounted for all the variables.  However, if you consistently find situations where you're getting a 2-to-1 reward-to-risk, you will tend to make money: you have a built in margin of safety that seeks out much more reward than risk. 

Even if you're wrong from time to time, you probably have a reasonable chance of making out on the trade, since you will make a mistake that works for you (and not against you) once in a while to balance out the inevitable mistakes.  

How does this fit in? If you pay too much for a stock, your reward-to-risk is probably looking a lot worse than 2-to-1.  In fact, you might even be risking more than your possible upside in some cases. If you paid so much for a stock that realistic upside is only 30% and downside is 60%, that's a reward-to-risk of 0.5-to-1.  That's terrible.  Just remember that if you overpay for a stock, any reasonable valuation model will probably turn in a fair value that is lower than today's price, not higher.  That leads to very unfavorable reward-to-risk ratio! 

4. Search for proper context

Going back to the dead money example, it's not fair to say a stock has gone nowhere for 10 years if you're comparing today's much improved valuations to bubble valuations when people were not thinking rationally.  If you know people were frothing at the mouth to get a hold of tech stocks 10 years ago, that's not really a fair comparison to use a sideways stock price as justification for proof that a stock is dead money.  If that sucker was trading at 60 times earnings 10 years ago and it's now trading at 15 times earnings, it's looking a lot better now.  

A lot can happen for 10 years.  If a drastically overvalued stock improves sales and earnings 10 years ago without improving its share price, I might start to get interested.  I would have written that stock off 10 years ago, so stop telling me it's dead money! It was dead money 10 years ago when it was trading way too high.  If you can manage a reasonable price today, it is not dead money.

18 Comments – Post Your Own

#1) On March 19, 2011 at 10:45 AM, kdakota630 (29.74) wrote:

+1 rec.

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#2) On March 19, 2011 at 11:21 AM, TSIF (99.96) wrote:

Point made and well supported. But the opposite is still very possible. It could have been dead money ten years ago and could still be dead money today.  One should neither assume it still is nor that it won't be, but to your point, give it fresh DD and a fresh look without the dead money mentality dulling your senses.  Unfortunately, however, some that were dead money that are much better aligned to valuation will still have a stigma, that limits investor appetite, but over time your risk is still much lower and it could wake up.

Good stuff!

TSIF

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#3) On March 19, 2011 at 11:44 AM, MKArch (99.71) wrote:

I just bought some CSCO for exactly the reason you just pointed out Babo. It's earning something like 3X what it did a decade ago and trading for a tiny fraction of what it did a decade ago. It now look like a bargain.

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#4) On March 19, 2011 at 12:18 PM, Momentum21 (97.26) wrote:

great post, thanks...

I have some thoughts to add but wanted to start off by broadly commenting that I really think the perspective will vary by your goals/strategy. Some will make an "investment" for the short-term that might be overpriced to take advantage of momentum. Others would prefer to initiate long-term positions upon cheaper valuations.

I am assuming that you are taking the perspective of a pure value investor. In this case I think there is definitely a component of how you manage your capital with regards to a stock once you determine it is undervalued...this will ultimately determine your rate of return over various time frames. 

When investing my IRA in a fund I use past performance to assess where I deploy capital. Since I take a shorter term perspective with my "discretionary fund" of 40 stocks, past performance is not important and I also realize that downside momentum on value plays need to be considered. Ultimately the market will determine a valuation on any given day and one needs to be nimble (and patient) managing that... : )

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#5) On March 19, 2011 at 12:21 PM, SultanOfSwing (99.04) wrote:

It looks like you're blogging about once a month now, so I feel I need to get a reply in while I have the chance.  :)

In my view, multi-national companies like WMT and other Dow Jones or S&P 500 participants are much more subject to macro events than, say, microcap stocks.  So when you speak of risk-reward ratio, it's often important to skew that ratio in your favor by waiting for buy and sell opportunities to present themselves.  In the past 20 years, I can think of a few big ones: Black Monday, Tech Bubble and subsequent crash, 9/11, Housing Bubble and subsequent crash, the "flash crash", and now Japan.

Take a player like TMFUltraLong, for example.  Not to pick on him, but looking at the start dates for many of his picks.  He zoomed right to the top of the game by maximizing the opportunity afforded by the generational lows of 3/09/09.  Apparently, his strategy has changed now to shorting small caps and pumped stocks.

So when analyzing stocks, technical analysis needs to be considered as well as fundamental analysis.  It's never one or the other.

I agree though, good stuff!

SoS

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#6) On March 19, 2011 at 12:23 PM, Valyooo (99.60) wrote:

You make some good points, but do you think WMT is ever going to be deserving of a higher multiple?  It's so large already, that nobody else is going to want to pay for a company with much lower growth.  If nobody else is going to pay a higher multiple for WMT, then the only way it is "cheap" is if you plan on buying the entire business.

I don't really see the growth in WMT, so I think you would be better off buying a bond.  Also, it has hugely undeperformed the market since the March 09 bottom, when stocks were very cheap, not expensive.  Wouldn't you say THAT is dead money?

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#7) On March 19, 2011 at 12:46 PM, Momentum21 (97.26) wrote:

CSCO is a great example for this post...

I happen to feel it is undervalued here and offers lower downside risk at current levels (17.14). I am therefore more comfortable "leveraging up" with capital I would reserve for shorter term investing. If I was trying to deploy a lump sum in one stock over the long haul I am not sure CSCO would be that choice even though it is currently my largest holding. Long term, past performance would weigh more upon my decision. 

 

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#8) On March 19, 2011 at 12:59 PM, SockMarket (59.78) wrote:

bbabo (or I guess tbabo now),

excellent post, as usual. I certainly hope youre right, I just bought some JNJ :)

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#9) On March 19, 2011 at 1:10 PM, HarryCarysGhost (99.75) wrote:

One could make the same case for microsoft, stock price stays stagnant for the most part. But in a severe downturn it never got hit that hard.

And the dividend remained true.

So it boils down to what your looking for. Personally I don't like Walmart, shopping there sucks. And I can't wash away the scummy feeling that I'm empowering China with every purchase.

DCA and DRIP are the way to go with these type of stocks

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#10) On March 19, 2011 at 1:24 PM, HarryCarysGhost (99.75) wrote:

http://www.youtube.com/watch?v=SX86viXrV_4&feature=related

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#11) On March 19, 2011 at 9:21 PM, oakbrookkeith (< 20) wrote:

The points made in the article are solid, but miss a few of my key screens.  When I research a stock I'm looking at financials, the basic business, three year financial and sales results. And I am looking at growth rates while I consider beta.  

Companies that cannot innovate into new areas of growth will always be dead money -- they may have a great beta (wmt, mcd, pg, intc, etc.) but they cannot continue upside momentum if they are serving business lines that are already fully exploited.

Then there is the quality of management.  Micosoft has missed so many business opportunites that the crime is why the board has let Balmer stay so long.  Same at intc and wmt.  A stock becomes dead money when the business model is fully ripened and management is unable to conceive and exploit the next innovation.

I believe this is the case at Cisco.  Chambers saw the internet and networking and fully deserved the large multiples he had in 1999 (+40).  But he has not been able to conceive beyond cable and has missed internet 2.0 in large part.

 Lastly -- there is the law of big numbers.  Apple has defied them due to Steve Jobs ability to conceive new business lines.  McD has defied them for the same reason.  Mrs. Softie and others have been trapped by them along with their investors as they stayed safely within what they knew.

I don't believe in TMF's adage of owning a stock for the long term.  I only have three holdings of more than six years, but I've made money on many based on Buffets rules of when to be greedy and when to be fearful.  While I never buy a stock I don't intend to hold for a three year period,  I have found that over the last 20 years most are 24 month investments.  Let's see, Blockbuster in '94 -- couldn't find a video on a Friday night.  Now you can't find Blockbuster.  Compaq owned computers, etc....

But I think I've finally learned how to avoid the WMT's, the INTC's, the MSFT's and the GE's of the stock world.

Knowledge of the current business, an understanding of it's future potential, an assessment of current management, realistic judgements of future potential and an understanding of why I am buying this company all help define the purchase price I feel is a value and the selling price and timeframe of ownership I am considering.  I continue to evaluate but I now know why I am buying and under what terms I expect to sell. 

My portfolio and my lifestyle is better for it. 

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#12) On March 27, 2011 at 10:58 AM, valuemoney (99.99) wrote:

If just everyone would understand your point....but they don't.

I am VERY glad about this! And glad people don't understand how to look at a balance sheet, and buy stocks because everyone else is buying them.

It gives me good entry points on the equities I buy!

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#13) On March 30, 2011 at 6:25 PM, Feratu (< 20) wrote:

Interesting post.  I appreciate the insight. Looking at a 10 year stock chart the price of WMT has fluctuated between $38 & $60.  Alas it depends where you bought it.  Something to think about for most of 2006-2007 stock traded in a narrow range ($39-$46) and than exploded to a high of $60 eight months.  Did the fundamentals all the sudden change drastically for such a huge company?? I doubt it

I think there are better places to invest. Stock chart for WMT looks unfavorable at the moment. I think you will see this wax and wane between $51 and $56 for a long time.  Technically at the moment this is dead money - why place your money here now? Lawsuit for discrimination just hit as well, not sure whether it has any substance. 

I can read balance sheets and follow fundamentals - sometimes Market forces don't care about them and what you think the stock should do or it's value. 

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#14) On March 30, 2011 at 6:36 PM, TheDumbMoney (39.25) wrote:

Glad you're saying it.  I've said it twelve ways to Sunday but as a nobody it matters not what I say.

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#15) On April 01, 2011 at 12:50 AM, TMFBabo (100.00) wrote:

I'll start off with this: this post was not meant to be a massive bull case on WMT - I just meant to say that one should not use a sideways or declining stock price as one of the top reasons to avoid a stock.  If a business improves its performance over the years as stock price comes down, it may start to become more attractive, no matter what the stock price has done over a certain time period.

I posted a second version of this post on the Alpha boards and it ended up much better.  I typed this one checklist style (just type it up and hit "post") and I noticed 3 errors on it within 5 minutes of posting.  I'm very impressed that checklist can just type out those really long blog posts and hit "post."

In response to many people, CSCO, JNJ, and MSFT are all great examples.  I think the tech names are a bit better because they were so fantastically overvalued during the tech bubble, but I guess a lot of other stocks work too.  I guess that's why we had a sideways market for so long - the bull market of the 80s and 90s was one of the greatest (if not the greatest) ever, right?

I could argue bear points for every company mentioned, but the one I will discount is the "stock price going nowhere" argument - if a stock is truly dead money, there will be real reasons for the business faltering that can easily be brought up.

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#16) On April 02, 2011 at 12:42 PM, TMFBabo (100.00) wrote:

@Valyooo: Without multiple expansion, I expect WMT to grow (especially Internationally) mid to high single digits going forward.  This isn't the hold high growth WMT, but I do expect growth.

In early 2009, I was buying cyclicals and micros.  I think WMT is the type of stock you buy when the market has crossed fair value.  It will underperform on the way up and outperform on the way down.  

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#17) On April 02, 2011 at 5:04 PM, TMFBabo (100.00) wrote:

*old, not hold

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#18) On April 07, 2011 at 12:43 AM, RedondoGolfer (64.10) wrote:

Could you expand upon your methods for evaluating risk-reward or point me at resources where I can better understand how to structure this type of analysis. Thanks in advance.

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