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When investing in the market, it is smart to consider stocks tainted by negativity. Most investors, however, are uncomfortable investing in negativity. It is easy to understand why. Targeting the stocks of problem-plagued companies runs counter to the natural instincts of an investor. It is counter-intuitive to seek out and embrace negativity.

Why, then, should investors target stocks enveloped by negativity? The short answer is simple: because that is where the bargains are.

In a perfect world, it would not be so. Both problem-plagued and problem-free companies would be appropriately priced by the stock market. In a perfect world, it would not make sense to specifically seek out negativity.

But the stock market is far from a perfect world. The market’s discounting mechanism can get woefully out of whack when pricing problem-plagued companies. One causal factor is that investors allocate too much weight to a company’s short-term problems and not enough weight to their likely long-term resolution. Another causal factor is that investors are prone to linearly extrapolate the existing conditions of a business into the distant future.

The net result is that problem-plagued companies are priced as if the environment will not change. The stocks of these companies often sell at bargain basement prices. At the other end of the operating continuum, companies that are thriving are also priced as if the environment will not change. The stocks of these companies are usually fully valued, and often overvalued.

Viewing any company through a linear lens is a mistake. The essential essence of business is cyclical, not linear. All businesses struggle with a wide variety of cyclical forces. Sometimes a business struggles with a minor cycle, sometimes with a major cycle. Cycles can be external (such as in a recession) and they can be internal (company-specific). Internal cycles can be both complex and varied. For example, the women’s apparel segment of a department store chain might be on a cyclical upswing while its cosmetic business is on a cyclical downswing.

Are problem-free companies lower-risk investments?

Many investors attempt to mitigate risk by buying problem-free companies while avoiding those with problems. Ironically, buying these companies can be a higher risk strategy when compared with a well-selected portfolio of problem-plagued companies.

How can that be? How can buying negativity be a lower-risk strategy? It is lower risk when the price-to-value gap is wider. This gap tends to be outsized when negativity stains a stock. It is axiomatic that, as the level of negativity increases, the probability that there is a considerable price-to-value gap also increases.

Most people would rather buy a fairly priced stock of a high-quality business than the stock of an undervalued low-quality business. They think paying a price that approximates value for a high-quality business is a lower-risk investment.

They are wrong. The astute analyst already adjusts for the quality variable in the valuation calculation. High-quality companies are marked up in the valuation calculation. They generally merit a sizeable premium. Low-quality business models are marked down, sometimes severely, in the valuation calculation process.

Consider this example. The stock of a high-quality company is appropriately priced by the market (price = value), while the stock of a low-quality business is undervalued by 50 per cent. Which stock carries more risk? Buying the stock of the high-quality business is much riskier than buying the stock of the low-quality business. Since quality is already reflected in the valuation calculation, risk assessment revolves around the issue of price versus value.

For investors who prefer problem-free companies to those plagued with problems, there are other issues that have to be considered. There is no such thing as a permanently problem-free company. It is fair to say that there are really only two categories of companies: those that have problems and those that are going to have problems.

Sooner or later, every problem-free company suffers through a cycle of problems. Investors should resist paying for the stock of a problem-free company on the assumption that it will be immune from problems.

Another issue for investors involves the known versus the unknown. To the investor, the unknown is a source of concern. When everything is known there is nothing to fear.

For a company enmeshed in an imbroglio of negativity, management has little or no incentive to paint a rosy picture. Particularly when new management comes on board (as is often the case), there is a powerful incentive to get everything on the table, to make known all of the bad news so that the company can move forward.

A shrewd investor finds comfort in such a situation. Everything that is known, from operating data to statements by management to the relative quality of a company, can be analysed, weighed and measured.

The writer is a portfolio manager for Alsin Capital and the Turnaround Fund. arne@alsincapital.com

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