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Bargains don’t arrive at the stock market wrapped in pretty packages tied with a bow. You are not going to find bargain stocks among companies that are thriving, that are consistently generating impressive operating performance. The stocks of thriving companies are almost always fully valued and frequently overvalued.

If you are a true bargain hunter, there is but one place to look. That is in the stocks of companies that have hit a rough patch, that are operating at subnormal levels because of short-term problems. It is fair to say that as the level of negativity surrounding one of these stocks increases, the likelihood that the stock is materially undervalued also increases.

Why are the bargains in the stock market almost exclusively in companies surrounded by negativity? It is because of the linear bias of investors. Even though the essence of business is inconsistent and cyclical (in varying degrees of magnitude), investors insist on viewing companies through a linear lens. Investors look at the operations of a particular company and linearly project more of the same into the distant future. The net result is that thriving companies tend to be overvalued and underperforming companies tend to be undervalued.

For the risk-averse investor, there is a way to capture the upside from investing in struggling companies, which is still consistent with a minimal level of risk. This involves more than a consideration of the variables that most investors are familiar with, such as a strong balance sheet (staying power), durability of the end market (demand will not disappear), and a skilled and motivated management team.

The minimal risk opportunities are in struggling companies that have these attributes, and one more. That attribute involves causation; that is, when the causal link to a company’s struggles is traced to cyclical factors, there is often a minimal level of risk for the investor.

Imbalances in supply or demand cause cycles. These imbalances naturally self-correct. Capital flows into areas of high profitability to correct insufficient supply, and out of areas of low profitability to correct excessive supply. There are all sorts of naturally occurring cycles that the astute investor can take advantage of. There are cycles in housing, metals, chemicals, most retail models, property/casualty insurance, energy, semiconductors and many, many more sectors.

It is important to note that the majority of struggling companies do not meet the criteria above. For most companies, their struggles are not solely a result of cyclical issues. Most struggling companies have internal issues. These are problems that are specific to the company and usually within the company’s control. For example, the problems at General Motors (in which I have no position) are not a result of the supply and demand cycle for automobiles. The company has internal problems such as a bloated cost structure and an inability to design and produce cars popular enough to stem the erosion of market share.

A minimal-risk investment opportunity in a struggling company exists when there are no internal issues, where the only reason operations are depressed is because of an external, cyclical factor. To qualify as a minimal risk opportunity, a future change in the cyclical factor must be certain.

For example, history shows that flat yield curves (when short-term interest rates are close to long-term interest rates) are temporary and are subject to a natural self-correcting cycle. It is inevitable that the current flat yield curve will steepen – either short-term interest rates will decline or long-term interest rates will increase. The timing of the steepening of the curve is impossible to predict. That the yield curve will steepen is a certainty.

Commerce Bank (in which I own stock) is an example of a stock that meets the minimal-risk criteria above. Its internal operations require no fixing. In fact, it is reasonable to label it the best bank in America if the key criterion is the ability to achieve organic growth in its deposit base. While other banks grow via acquisition, if they grow at all, Commerce has a long history of growing deposits at 18-20 per cent a year through de novo expansion.

The earnings at Commerce have been under significant pressure because of a single problem. That problem is a cyclical factor that is external to the company – the flat slope of the yield curve. A flat yield curve masks
the earnings power of banks, generally, but it is accentuated at Commerce because of its prodigious deposit
growth rate.

When the yield curve steepens again, look for the stock of Commerce (currently at about $34) to jump in value. By my calculations, if the yield curve returns to a normal slope by the end of this year, Commerce will generate $3.11 and $3.57 per share in earnings in 2008 and 2009, respectively. Because this is a premier bank with an exceptional growth rate, Commerce historically commands an 18-20 price/earnings multiple. That suggests Commerce stock will double in the next 18-24 months.


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

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