Shares digital

Peter Webb explains how to beat the market with a contrarian view and a little know-how

A phrase often quoted in the stock market is ‘Never catch a falling knife’. It is typically used to describe a common mistake that investors make when buying a falling share. They generally fail to differentiate between when the price is down for long-term rather than temporary reasons and end up selling at a hefty loss.

For most market participants, a falling share is something to avoid but for a true value investor, a falling share price often arouses interest and may trigger a purchase. One difficulty with this style, though, is that our brain is wired in such a way that we are always looking for external confirmation of our decisions. In this case, ask the market what it thinks and a rising share price indicates ‘buy it before it’s too late’ and a falling one ‘nobody wants to touch this, leave well alone’. To be a good investor, you generally need to do the opposite.

The corporate life cycle can lead companies and management to value destroying vacillation. If you are aware of this cycle, you will also be aware of how this torpor can be broken. What you are looking for is ‘something new’; a break point in a company. Proactive management or a change in strategy can often bring about a reversal in a declining business. Continuity may have been the goal for some time and the business is so geared to it that the key goals that got it there in the first place are forgotten. The change in fortunes often presents the chance to throw away corporate inertia and bring in long overdue changes.

When the chips are down

On 23 January 2003, something caught my attention; McDonald’s served up their first ever quarterly loss. It attracted a lot of publicity, most of it negative. The shares closed the day down $0.40 to $14.96. Jim Cantalupo had been brought back from retirement to revitalise the company and this was his first set of results. I listened intently to the subsequent conference call.

The ‘loss’ was actually a profit. The accounting loss came around from a heavy exceptional charge of over $800 million that the company took in order to close unprofitable restaurants and restructure. Cantalupo admitted that McDonalds had ‘taken its eyes off the fries’ and that there were a series of measures under way to inject some focus and discipline into the business. Admitting there is a problem is probably the hardest things for companies to do. Once identified, you need some action to put the reforms in place. For some companies, this is equally as hard. In Cantalupo, though, McDonalds had the right man and he put forward a number of refreshing measures to address the decline and torpor. It often needs a rocket like this to get the whole model moving again.

My guess was that earnings would rebound at some point and with it so would the share price. The shares were down 70% from their multi year high of $49.60 and I started to get really interested sub $15, where it looked a bargain. You can see that by keeping an eye of the cash flow, rather than the accounting earnings, a different picture emerges. As I started buying at around $15, they continued to fall but eventually bottomed at $12.10. Before long things started to turn around and the market began to realise this and put that back into the price. Wind forward to 2007 and my 2003 purchase now trades at over $50 with a dividend yield approaching 10% a year on my original purchase price. With cash flow now at four times my purchase price, this is now a holding that will be difficult to justifying selling. You don’t need many winners like this to compensate for the odd error in judgement.

While this example required an element of judgement, others are often clearer and issues that are completely temporary are favoured over more ambiguous ones. It’s not out of the question, of course, that a strategy to reform the company could fall flat, so you can’t rule out the need for another chance to turn things around. This being the case, make sure your key points for getting involved are backed up with a company that has a demonstrable competitive advantage and a strong financial standing and make sure you buy it at the right price.

Companies that are out of favour tend to trade below their intrinsic value and the price often does not fully discount a potential recovery in the fortunes of the company. While recovery is not assured, you are likely to have limited downside and lots of potential upside. By identifying favourable circumstances within solid companies at a fair price, you mitigate a large amount of risk. During my investing career, I have caught many ‘falling knives’ but assure you I still have plenty of fingers left. n