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Christopher Browne: Is This a Real Bargain Stock or Not?

- By Robert Abbott

In the previous chapter of "The Little Book of Value Investing," author Christopher Browne explained how he created a list of potential acquisition candidates. The most fundamental criterion of these candidates was that they were selling at bargain prices.

But why were they cheap? That's the critical question addressed in chapter 11; are they bargains because they are going through a temporary rough patch or do they have severe, long-term problems that could land them in bankruptcy?


At the time this book was published in 2006, there were a number of high-profile examples. Browne wrote, "At various times in the past few years, names like Enron, Global Crossing, MCI, U.S. Airlines and Pacific Gas and Electric might have popped up on a list of value candidates whose stock price had fallen significantly. However, these companies ended up filing for bankruptcy, and shareholders lost a significant portion of their investment if not all their money."

Why do some good companies get into trouble? Browne had some ideas, writing, "The first and most toxic reason that stocks become cheap is too much debt." Companies with reasonably strong cash flow borrow heavily, believing that continued growth will allow them to handle the interest and principal payments. As we know from hindsight, and Robbie Burns, "The best laid schemes o' mice an' men / Gang aft a-gley."

How much is too much? Browne cited the rule of thumb used by his mentor, Benjamin Graham, saying, "A company should own twice as much as it owes. This philosophy has helped me avoid companies that owe too much to survive."

Then, there are stock prices that drop because they did not meet estimates. Often that happens when a company does not meet the earnings estimates of Wall Street analysts. As we know, analysts focus on the short term, quarter by quarter, rather than long term, which we might define as three to five years or longer.

Analysts' words have power because they are followed closely by big institutional investors and individuals. "Countless investment systems are built on the concept of buying shares when a company exceeds the analysts' estimates and selling shares when it doesn't. This thinking prevails even though quarterly or yearly earnings estimates have been proven to be notoriously unreliable," Browne said.

Those systems continue to exist because analysts are not paid for the accuracy of their calculations, but for the commissions they earn for their firms. As the author pointed out, large and good companies are frequently pushed to new lows because they missed the estimates of analysts who have no idea what good and bad companies look like. The silver lining in this cloud is these systems create opportunities for value investors.

Next on Browne's list of conditions that get companies into trouble are business cycles. Companies that are part of the cycle enjoy popularity when the cycle is moving up, but are unpopular when the cycle heads down. It's not that the companies are changing, but that the economy dictates how much consumers will spend. Products such as autos routinely go through this, as do industries like steel and construction. What value investors should remember is that economies always rebound, sooner or later.

But beware of cyclical companies with large debt loads heading into the downward half of a business cycle. Investors can avoid such potential trouble by simply staying away from companies that are overly leveraged.

As this book was being written, labor contracts were also a source of bargain-priced stocks. The author noted, "During good times, some companies and industries cave into labor union demands that were affordable at the time. Little did they realize that they were mortgaging their future. As new competition unburdened by costly labor contracts enters their industries, their profits disappear."

Browne pointed to the big three auto companies and the major airlines as examples. He added, "Although holding on to expensive contracts may or may not benefit management or the unions in the long run, the one person that most assuredly does not benefit is the stockholder."

In the same vein, older companies may also face trouble if they have unfunded pension liabilities. In other words, companies have made promises they cannot keep. Again, auto companies are cautionary examples. And because of that, they should not stay on your short list.

Also watch for companies that face increased competition. The author points to Chinese imports that were wonderful for consumers, but trouble for shareholders in domestic companies. Ironically, in 2019, China itself is experiencing this as other countries, such as Vietnam, underbid it on products that depend on low labor costs.

Obsolescence can also be a source of bargain-priced stocks, as a company's products become outdated. As Browne noted, "The rate of 'creative destruction' has never been faster. Newer and better products turn up every day, making the older products obsolete. The new products are a boon to the consumer but the bane of the legacy company."

Finally, share prices can fall because of corporate or accounting fraud. It's a rare occurrence, but such crimes do happen and shareholders end up with the collateral damage.

What's to be done in the face of all these hazards potentially facing value hunters? Browne has some ideas and began by recommending that investors focus on companies in industries they can understand. Warren Buffett (Trades, Portfolio), for example, used to buy only companies that he could clearly understand and, by doing so, would avoid many of the problems listed above. Simple companies offer fewer places to hide bad news.

Speaking of Buffett, Browne also recommended companies with strong moats, such as those with strong brand names or the size to scare off potential competitors. As he wrote, "Does anyone think they could start a business that could compete with the likes of a Wal-Mart (WMT)?" Moats may not last forever, but while they do, they ensure strong margins and strong earnings.

Browne likes companies he understands even more when there is an ongoing need for their products or services. For example, banks and credit card companies are reasonably simple businesses that consumers use every day. Similarly, there are consumer staples, as well as food and beverage stocks. Those with strong brands should thrive as well as survive.

Finally, the author concluded:


"I approach my list of investment candidates with a healthy dose of skepticism. My best friend in the whole world when it comes to building my inventory of value investing opportunities is the no-thank-you pile. If there is something you do not understand or are not comfortable with, in the no-thank-you pile it should go. If a company has too many problems--too much debt, union and pension problems, stiff foreign competition--on the pile it goes. I have the luxury of filling my store with merchandise I am comfortable with and want to own for the long-term wealth building it offers."



Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

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