To print article, click
Print on your browser's File menu.
Go back
Go back
Posted 2/8/2001
Related Resources
Keep track of Victor Niederhoffer and Laurel Kenner's picks on their Recommendations page.
Details
 |
|
The Speculator
Roll the dice on a money-losing company
In this satisfaction-guaranteed world, the best deals may lie in businesses with a red-ink past and a blue-chip future.
By Victor Niederhoffer and Laurel Kenner
Out of this nettle, danger, we pluck this flower, safety.
-- William Shakespeare, Henry IV
Sometimes we're too frightened to get out of bed, what with all the warnings, cautions, flashing red lights and limited warranties lying in wait.
 Money Plus. Easy online tools and free Bill Pay, too. |
Our toothpaste advises we get professional help if we swallow it. Our lip balm warns against use in the eyes. We avert our gaze from the labels on our medication bottles listing complaints mentioned by any of thousands of subjects during years of testing.
Just getting in the car is a trial. The seatbelts insist on being used. The rearview mirror warns that objects appear closer than they are. The engine won't start until we agree to keep our eyes on the road instead of the Global Positioning System screen.
All these solicitous warnings have turned us into a nation of wimps. The only way we get to experience risk is vicariously. No wonder that "Survivor" is the most popular television series, that the XFL's marketing pitch is "real men playing real football." Or that the most popular newspaper features stories of frail 85-year-old ladies holding bears at bay. Or that a little book containing tips on escaping crocodiles is a best seller. Or that Louis L'Amour's adventure tales have outsold any other novels.
After running the gauntlet of bathroom cautions and being babied by our cars, by the time we get to the office the last thing in the world on our minds is to take a chance on a risky stock -- especially after last year. The company might fail. It might not comply with accounting standards. The warning it just issued on inventory backlogs, heightened competition or narrowing margins might cause the price to fall. The white-shoe brokerages might lower their recommendations from buy to hold.
As Shakespeare points out, though, where there is widespread fear of danger, safety often arises.
Fear of dangerous stocks
Investment managers fear to recommend dangerous stocks that might leave them with egg on their faces and subpoenas in their pockets, and investors eschew such stocks because they're afraid to go against the grain. But the very absence of buying in these stocks creates a reduction in demand that, other things being equal, leads to such stocks being valued less favorably than they would without the fear factor. Conversely, investors rushing in to buy companies with no perceptible danger creates values that are too high.
Nowhere in the market is the fear of failure more prevalent for professionals than in the class of companies that are losing money. If these companies continue to lose money, they might actually go out of business. If they go out of business, they might not, in retrospect, be considered prudent investments for pension and profit-sharing funds. If the potential liability from imprudence isn't enough to forestall a purchase, consider the ridicule that fellow investment managers might heap if the stock falls drastically on continued bad news.
Further, what prudent investor in a fund -- who cannot get out of bed without warning bells and whistles sounding -- would consider buying a fund that actually selects such issues?
What many investors overlook is that companies with deficits might someday turn into companies with profits. Animals that go through long periods of nurturing before being thrust into the adult world often live the longest and have the most strength. Baby elephants, for example, stay with their families until the age of 11 or 12. Likewise, companies that go through long periods of using more resources than they produce often grow up to be elephants, in size and usefulness.
The same negative factors that cause a deficit can also be positive factors that build a base for a very strong future. Customers and employees can be costly to find. Research can take time to be translated into profits. Plants may take time to build and may actually not work at maximum efficiency shortly after completion.
Two elephant stories
Take Integrated Device Technology (IDTI, news, msgs), a Santa Clara, Calif., chip maker. It was formed in 1980 and went public in 1986. In 1998, the company managed to lose $300 million on sales of $600 million, and by the end of that year it was trading near its offering price, at an adjusted $6. Book value per share had fallen to $2. Things couldn't have looked bleaker.
We can almost hear the derision that would have greeted a money manager proposing a purchase of Integrated Device. After all, the company still had a market value of almost $500 million. Perhaps they should have ordered an extra supply of red ink?
But no, the red ink wasn't necessary. Integrated Device unveiled a new chip and shifted its marketing focus. Earnings grew to $130 million in the fiscal year ended March 2000, and the price conveniently quintupled in 1999, to an adjusted $29. On Tuesday, it closed at 40 7/8.
The story of Cypress Semiconductor (CY, news, msgs), which quadrupled in 1999, is qualitatively similar. Who would have bought it in 1998, when it reported a $105 million loss? And didn't its price seem lofty at $8, giving it a still-hefty market value of $800 million? Perhaps the buyers were those who forecast or hoped for the turnaround in earnings, which did materialize, to the tune of $91 million in 1999 and $278 million in 2000.
We're aware that theorists, like writers and golfers, are much better at propounding advice off the course than in coming up with winning shots. We are not immune to that failing. However, because we take a pride in our work beyond the dollar or the clock and have the utmost respect for our readers, we are not about to unload anecdotal evidence or a bunch of untested dogma, no matter how seemingly logical, without a test.
Analyzing the losers
We originally visited this issue in a tangential way in our Nov. 9 column, "Why high P/E stocks are good for you." We examined the performance of Nasdaq 100 companies that registered deficits in 1997, 1998 and 1999. We found 44 such companies and saw that that their stocks doubled, on average, in the next year. We listed 12 Nasdaq 100 stocks that were then in deficit and suggested that these were candidates to buy at the end of calendar 2000.
Eleven of those 12 stocks have gained in 2001, with the highest return from Legato Systems (LGTO, news, msgs), which went up 132%. Only one, Adelphia Communications (ADLAC, news, msgs) declined, falling 15%. The average change of all 12 comes to a quite satisfactory 25%, compared with the 5.6% year-to-date gain in the Nasdaq 100 itself.
Today, we look at deficit companies in the S&P Midcap 400. We didn't use computerized databases, because we find them replete with survivor bias and date-of-announcement ambiguities. Instead, we took the S&P stock guides for 1997, 1998 and 1999, thereby using data that would have been available to investors at the time. For each issue, we compiled a list of companies that S&P listed as S&P 400 Midcap members. Next, we looked at the last 12 months' earnings. Finally, we took the year-end closing price listed in the stock guide.
We found 120 companies that actually registered deficits for the trailing 12 months during those three years. On average, they returned an average of 22% in the next 12 months, versus 12.7% for the 1,080 companies that made money.
Furthermore, the larger the deficit (normalized for price), the larger the return.
TABLE 1
Average return of S&P Midcap 400
deficit companies in next year (1997-1999)
| Deficit Class | % Return |
| Largest sixth | 38 |
| Second-largest | 42 |
| Third-largest | 26 |
| Fourth-largest | -5 |
| Fifth-largest | 29 |
| Smallest | 2.6 |
Note that the 40 companies with the worst deficits, in classes 1 and 2, returned 40% on average in the following years. Those with the smallest deficits returned only 3%. We speculate that the reason these latter companies performed so poorly even though they were so close to reporting a profit was their failure to find the wherewithal within any of their balance-sheet items to reduce a liability or increase an asset enough to move from red to black. That inability to go the extra mile, to persuade the auditor to look the other way, when they were so close, is somewhat of a sign of weakness.
In aggregate, the variability of the mean return for these 120 deficit companies is about 5%. Thus, statistically speaking, we can have a reasonable confidence that the 9% excess return that these companies showed was not due to chance.
Warning: The Speculators have determined that buying deficit companies may be an appropriate strategy for stocks pre-selected as standard-bearers by committees that assemble major Standard & Poor's and Nasdaq indexes. However, serious financial injury may occur if you buy stocks of money-losing firms not approved by these veteran stock-pickers. Known side effects include headaches, losses, marital difficulties and in some cases, financial ruin.
TABLE 2
| S&P Midcap 400 companies with negative income |
| Avocent (AVCT, news, msgs) |
| Broadwing (BRW, news, msgs) |
| CheckFree (CKFR, news, msgs) |
| COR Therapeutics (CORR, news, msgs) |
| Dun & Bradstreet (DNB, news, msgs) |
| Edwards Lifesciences (EW, news, msgs) |
| Gilead Sciences (GILD, news, msgs) |
| Grant Prideco (GRP, news, msgs) |
| Incyte Genomics (INCY, news, msgs) |
| Legato Systems (LGTO, news, msgs) |
| Millennium Pharmaceuticals (MLNM, news, msgs) |
| Network Associates (NETA, news, msgs) |
| Ohio Casualty (OCAS, news, msgs) |
| Ogden (OG, news, msgs) |
| Protein Design Labs (PDLI, news, msgs) |
| Six Flags (PKS, news, msgs) |
| Retek (RETK, news, msgs) |
| Sepracor (SEPR, news, msgs) |
| Sierra Pacific Resources (SRP, news, msgs) |
| Vertex Pharmaceuticals (VRTX, news, msgs) |
Because the list may have some practical value, we are including a list of companies in the S&P Midcap that are currently in the red, in Table 2. We found two, Edwards Lifesciences (EW, news, msgs) and Legato Systems, that had significant insider buying in the past three months.
As Legato has already gone up 132% this year, we aren't buyers. But we'll add Edwards to our recommend list.
We are mindful of King Henry V's remark to Gloucester: "Tis true that we are in great danger; the greater therefore should our courage be."
End note
Last year, one of the major errors that we made involved reporting various anomalies and allowing specific actions regarding them to hang. While in the main we were far too bullish last year, we are pleased to report that the big January swing in volatile stocks had a highly salutary impact on almost all the portfolios we recommended, in a similar fashion to the Nasdaq 100 deficit portfolio recorded above. This year, inspired by the requests of many of our readers, we're going to stay much more closely in touch with the actual entry and exit dates for all our recommendations.
Recent Articles
When the chips are down, buy, buy, buy, 2/1/00
5 battle-tested rules for a mystifying market, 1/25/01
3 solid stocks the market rebound missed, 1/18/00
more...
Only two stocks are left of the original five: Conexant (CNXT, news, msgs) and Nextel (NXTL, news, msgs).
Computing returns from the suggested sell date, one or two days after the column's publication, the average gain in the portfolio comes to 31%.
On Jan. 18, we recommended three additional stocks -- Hewlett-Packard (HWP, news, msgs), KLA-Tencor (KLAC, news, msgs) and Xilinx (XLNX, news, msgs), which brought the portfolio's return to 42% by last Tuesday's close. Last week, we recommended adding four chip stocks to that portfolio -- Motorola (MOT, news, msgs), Transmeta (TMTA, news, msgs), Teradyne (TER, news, msgs) and Viasystems Group (VG, news, msgs). This brought the total number of stocks to 10. They have fallen 7% since last week, bringing our return down to 32% year-to-date.
Victor Niederhoffer and Laurel Kenner both own shares in Conexant, Motorola, Teradyne, Viasystems, Transmeta and Xilinx.
MSN Money's editorial goal is to provide a forum for personal finance and investment ideas. Our articles, columns, message board posts and other features should not be construed as investment advice, nor does their appearance imply an endorsement by Microsoft of any specific security or trading strategy. An investor's best course of action must be based on individual circumstances.