Fool's gold

Saturday 1st September 2001

How to tell the good cheap stocks from the bad cheap stocks, explained by Roger Armstrong

Psssst! Want to buy some cheap shares? New Zealand has plenty. But as anyone who has bought a watch down a dark alley knows, sometimes the "Swiss mechanism" at the core of the bargain product is not what it is purported to be.

During my recently completed five-year stint in share broking, my company put together a strategy document every quarter. And every document contained a little piece saying the New Zealand market looked "cheap", but we were worried about the over-valuation of the influential US market (yes, we were trying to flog New Zealand shares).

While we were apparently proved right last year, the previous four years we would have ended up on skid row by betting on the New Zealand market versus the US. Over the past five years the New Zealand market has gone down 3%, while the US market has risen approximately 200% in New Zealand dollar terms. Why did this happen, if the market here really was (and still is) cheap? What about all those bargain stocks?

I suspect many of the stocks on the New Zealand market are like "fool's gold": they look like short-term bargains but deliver long-term disappointment.

For the share market to perform as a whole, either the local economy must grow strongly or the share market must be loaded with talented global companies. Our economy is low-growth and commodity-oriented, with high interest rates, low political guidance and a calypso currency. Our companies are mainly domestic or commodity stocks, many are poorly run and few have a true international outlook.

But even in the most barren soil there are often flecks of gold. The secret to investing in cheap stocks is to sort out the good cheap stocks from the bad cheap stocks. Many people think of "cheap stocks" as stock with a low price-to-earnings (P/E) ratio, but there are many companies that trade on low P/E ratios because they are "bad" companies - in nasty sectors, badly run, up against bigger and better competitors and so on. Such "bargain" stocks can sometimes produce short-term gains but over time they will mostly disappoint.

Finding cheap stock is simply about trying to buy companies for less than they are worth (which may not even mean a low P/E at all). The easiest cheap stocks to find are intrinsically "good" companies (or companies that have an emerging good core business) that are temporarily down on their luck and a little unloved by the market.

The most important difference between a good company and a bad company is in the return the company gets on money invested in the business. Each company has a "cost of capital": a required rate of return they must make on the money invested in the business to justify its existence. If companies make more than this "hurdle" rate they create value for shareholders (the good companies), if they fall short of the hurdle, they destroy value (the bad companies). For most New Zealand companies this cost of capital is 10–14% after tax.

Some good companies, such as Baycorp and Auckland International Airport, may be priced highly (on a big P/E) but usually still provide sound investment returns for new purchasers. Bargain hunters may prefer to look for good companies that are temporarily in hard times or out of favour, or to find good companies that the market has not yet quite recognised as such.

For example, the reason that Fisher & Paykel has been such a great performer this year is that it has only recently dawned on many investors how good the healthcare business is. F&P was perceived as a "bad" whiteware company for a long time, but 80% of the value now comes from the "good" healthcare subsidiary.

Similarly, consider Montana. This brilliant company was once hidden inside struggling investment company Corporate Investments, stretched financially by problematic property investment on the Gold Coast. But if you recognised seven years ago that Corporate Investments had a brilliant core business, you could have bought CIL/Montana at under 30 cents. It is now trading around the $4.50 mark.

And remember when The Warehouse tripped over itself in 1996, when it increased its total store area 47% in one year, while introducing a new computer system at the same time? Smart investors recognised that this was a temporary glitch for a great company and hoovered up the shares, now valued at $5.67.

So which good companies are currently facing hard times with a cheap share price? One "golden-core" company is Mainfreight. It has made a disastrous investment in Australia, but the New Zealand forwarding operation makes over 20% on its capital after tax, and in the last five years has close to doubled operating profit. If Australian operations break even (or close) at current prices you could buy into Mainfreight at a P/E of 7.5 times, low for a quality company.

Another out-of-favour company, which I suspect has a high-quality core business, is Tourism Holdings (THL), currently having a few problems with its Australian camper-van business. Many years ago, before THL invaded Australia and invited Britz into New Zealand, it had a dominant position in the local market similar to that it now enjoys on both sides of the Tasman. In those days THL made excellent returns, and it is a reasonable bet that when the Britz/Maui merger has settled down the company will once again make good coin from this growth business.

Scott Technologies (maker of production lines for whiteware companies) has averaged a 38% return on shareholders' funds in the last seven years. For the first time the company has fallen upon hard times this year, with a business downturn in its traditional US client base and a large loss-making contract in its first major foray into Europe. Scott appears to be a well-managed company, but given the downturn in the US it may be a little while before the company hits peak profitability again.

Air New Zealand might bounce back - if Virgin pulls out of Australia or it sells Ansett at a reasonable price - but history suggests the company will almost never make its cost of capital in the difficult airline business and will, in most years, produce poor share market returns. Over the past decade many people have been enticed into buying Air New Zealand shares by its low P/E or high dividend yield. But most have lost money.

Forestry (both wood growing and processing) is another underperforming industry. Fletcher Forests once traded at $2.50; Carter Holt Harvey used to trade at $3.50 and is now roughly half that. Both make lousy returns on capital employed and unless management start shrinking rather than growing the companies they are likely to be long-term dogs.

Tranz Rail is another company with a terrible record. Since listing it has invested over $400 million of new money into the business and seen its operating profit decline. On many occasions over the past five years it has looked "cheap", but this has always turned out to be an illusion; Tranz Rail has always managed to destroy more value. The board appointed new managing director Michael Beard and gave him licence to shake up the business. Some of his decisions may not be popular politically but drastic action is needed to turn a bad company into a good one.

Investing in "cheap" stocks is not always successful. The Mainfreights, THLs and Scott Technologies of New Zealand may not sort out their problems. But investing in recovery stories or unloved stock is never boring and can sometimes throw up large returns for the wise.

Disclosure of interest: At the time of writing Roger owns shares in F&P

Roger Armstrong
finn.ltd@ihug.net.nz

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