Fallen Angels: What You Should Know
The crux of our investment doctrine and process is the notion of the Fallen Angel. It was first used on Wall Street a number of years ago, and it alludes to a stock or bond that has decreased in value but will likely rebound soon. Those who can discern Fallen Angels hidden among the worthless securities in the market stand to profit greatly.
Not all depressed investments are Fallen Angels; in fact, the majority of them are not.
The two key elements of a Fallen Angel are:
When both of these criteria are met, we have a Fallen Angel deserving of our investment dollars.
Before getting too caught up in the prospect of future gains, there is much work to do. We must learn to distinguish between the fallen and the falling; this is quite crucial. We’ll utilize sound procedures to sort through the slew of domestic and international firms looking for our under-the-radar gems.
To lower risk while increasing potential gain, we’ll seek the best bargains on the market to lower risk while increasing potential gain. And once we’ve made it in, we need to begin thinking about how and when to get out with our money intact.
A general rule of thumb is to ignore the vendor’s claim of “get them while they’re hot!” As value investors, we usually buy when the stock prices are low. If they’re hot, then they might be overpriced.
However, if you find a company that meets your investment criteria and their stocks are cold, consider buying and waiting until their stocks rise (which will happen if the company is fundamentally strong and growing.
Shareholders Are Entrepreneurs in Their Own Right
Common stocks are seen as ownership interests in firms by investors seeking value, and they think like company owners. Our core objective is to identify businesses that have demonstrated a track record of outperforming the market.
Many people believe that the market already takes into account all available information. However, we believe that this is not always the case. We often look for opportunities where the market may be overreacting or oversimplifying a situation. This type of investing is called contrarianism and forms the basis of our Fallen Angels strategy.
We like to invest in firms at a substantial discount from our estimate of their real or inherent value in order to improve our chances of success. The finest businesses have consistently been increasing their shareholders’ equity at a rate of more than 15% per year, regardless of whether share prices are going up or down. They’re also seeing revenue and earnings expand by more than 10% each year.
The primary goal of value investors is to preserve money and, second, to expand it. One of the most essential initial decisions is how much of a trader’s portfolio should be invested in such assets as equities and bonds. The investor’s age, financial condition, risk tolerance, and overall objectives all come into play. Other factors to consider include present and future market situations.
The next step is to select appropriate investments from the wide range of available options. We’re looking for shares in outstanding businesses at a price that makes sense economically.
We seek opportunities that offer the highest expected yearly compounding return feasible, with a low degree of risk given the potential profit. Under the Fallen Angels strategy, we value predictability in corporate earnings potential and wait for those firms to go on sale. These prospective gems may be found by comparing their market price to your calculation of their real or intrinsic value. A screening approach is outlined in Chapter 10.
In a nutshell, we seek to accumulate high-quality businesses when they are cheap enough to provide a relatively safe price—what Ben Graham referred to as “a margin of safety.” Consider it this way: the lower you pay, the lower your risk and the higher your initial rate of return (dividend, cost per dollar of earnings, etc.).
If you were investing in income property, your initial rental yield as a percentage of your total investment would be far greater if you could buy the property at a discount.
When investing in stocks, bonds, and other securities, it’s important to remember that “less is more.” In other words, it’s best to know ahead of time what you want to buy, wait patiently for a sale, and then hold onto the investment for the long term.
Of course, there may be times when selling makes sense (as we’ll discuss later), but generally speaking, it’s best to stick with your investments for the long haul.
To reach our investment goals, we follow a strict three-step process:
- We search for undervalued companies that excel in their field.
- We buy stock in these excellent companies at reasonable or below market prices.
- We sell the stock when it no longer meets our criteria OR when the company itself is no longer meeting our standards.
The Three Things That Make Fallen Angels
Let’s briefly discuss what creates Fallen Angels before discussing how to find and evaluate them. These companies have dropped stock prices but have excellent prospects for recovering their original value.
Some factors that create Fallen Angels are under the companies’ control, and others aren’t. But all three forces share one thing in common-they can cause a temporary drop in the price per share of an otherwise great company.
The Business Cycle: Boom and Bust
The business cycle, which lasts an average of four years, is the first force that generates Fallen Angels. Depending on where we are in the economic cycle, various industry sectors such as technology, energy, manufacturing, finance, and so on will expand or contract. When a recession specific to their sector affects high-quality sectors and stocks, they temporarily become Fallen Angels.
In early 2008, as crude oil prices spiked, many analysts predicted$10-per-gallon gasoline because the price of a barrel had risen to almost $150. Pump prices were already $4 per gallon and higher, so people started buying more fuel-efficient vehicles–everything from hybrid cars to Vespa scooters.
The phenomenon in oil reversed course at the end of the year, with crude oil prices plummeting and pump costs to their lowest level in five years.
Since the price of oil stocks is correlated to the price of crude oil, they’ve ricocheted from being severely overvalued to being excessively undervalued. It paid for us to observe and wait for oil stocks to fall in bargain-basement pricing as long as the firms could pass our fundamentals assessment. The valuations on both sides moved rapidly away.
One-Time Catastrophe: Beware of Extreme Costs
My suggestion is to keep an eye on shifts in prices. They aren’t likely to stay that way for long. When stocks are extremely overvalued, selling them is a good moment. The prudent investor should buy when they’re similarly undervalued.
We know from past data that extreme pricing on the high or low ends is unsustainable over time. Market forces will eventually drive price tags back towards sensible levels. By recognizing these trends and looking for extremes, the intelligent investor may make use of them to their benefit.
A one-time catastrophe befalling a company that was previously solid and successful company might lead to the formation of Fallen Angels. Although no one would want an incident to strike a healthy corporation, I recognize such events are a godsend for stock market bargain hunters.
If you’re like me and have some experience but not much of it, start by reading the above section. Take note of the difference in tone between this and the previous sections; now, we’re talking about how to evaluate situations rather than how to get out of them.
If things aren’t going well and consumers are still coming through the door, or if they’re staying away for a while, we may be in luck. The drop in the firm’s stock is only a minor bump. Those who act swiftly can buy shares on the cheap from panicking investors. They will undoubtedly benefit as soon as the situation regains its justifiable price and rises back up.
Market-Crash: No Time is Better for Bargain Seekers
The third and final factor that can create opportunities for Fallen Angels is a market crash or widespread panic. When the masses are in chaos, it creates an ideal situation for those who know how to take advantage of it. After a market crash, plenty of cheap stocks will be available for investors.
When prices plummet due to widespread panic, even the best companies can be momentarily marked down. Panics and collapses are uncommon events, making it unwise to wait for them before investing. But when they happen, even the healthiest businesses can become Fallen Angels for a brief time.
After observing the markets for many years, I’ve learned that even during the exuberance of a bull market, bargains may be found for the discerning stock picker. There’s always a bargain to be found somewhere.
If you have a plan for determining what to buy, when to buy it, and when to sell it, you’re already ahead of the game. A system will help you keep cool during market panics or overbearingly optimistic buying sprees, as we’ve seen many times throughout history. The stock market indexes such as the Dow Jones and S&P 500 dropped dramatically in the first three crises of the new century.
However, those who understand the basic Newtonian principle that what goes up must come down (and then return to where it started) were in a better mood. We knew the “sale” signal on Wall Street would rise as rapidly as the indices fell. We began scouring through the rubble of the crisis, seeking tarnished gold nuggets. Believe me when I say we found more than a few.
Distinguish the Fallen From the Falling
A company whose book value grows at least 10% yearly is the ideal candidate for Fallen Angel status. Without regard to its actual worth, Wall Street has lowered the firm’s stock price. The greatest investment opportunities will trade at a discount of around half.
It can be intimidating for the most seasoned investors to begin their quest for bargains, but it’s almost impossible for novices. After all, you’ll be dealing with more than 10,000 publicly listed US and international firms in the stock market.
Reducing the entire market down to a manageable number of candidates can be done by using a screening method that pinpoints value currently unrecognized or underestimated by the stock market. In other words, we screen for companies that look undervalued.
I always start with one of the free stock screening programs available online, like Yahoo! Finance. These platforms allow you to sort through stocks based on your criteria. I usually look at earnings first because it’s such a reliable marker of a company’s financial health.
I’m only considering companies with 10% growth or more in their earnings over the past five years; my pool of options immediately becomes way smaller–usually only several hundred issues total.
Another indicator to consider is return on equity, which is earnings divided by book value. This factor should ideally increase at 15 percent or more for five years.
The debt-to-equity ratio is another key factor. Companies with high amounts of debt tend to
have trouble keeping up with their payments during an economic recession when sales generally go down. If a company’s debt outweighs its equity, it could signal potential danger for investors and shareholders.
Of course, the best case scenario would be if the company had no debts. But I would likely stay away from businesses whose number exceeds 25 percent.
Our goal is to screen companies and end up with a list of around 100. The real fun begins when we get to what’s called fundamental analysis. This is where we analyze the companies and try to find which ones are good investments.
Investment professionals have many ways of analyzing companies; some methods are better than others.
We can predict, to the best of our ability, we can predict the most probable future outcomes based on prior and present data. In other words, an analysis of a firm’s historical track record and current intrinsic value is useful.
We win more often than we lose when the odds are in our favor. We can enhance our chances by understanding how much a potential investment is worth to know if we are paying too much or not enough.
As previously stated, the higher the return on investment you pay for it, the greater its potential returns and risk; conversely, the lower you pay for it,
A company’s intrinsic value can be estimated using one of two approaches – a more straightforward method and a more involved one. Let’s begin with the former, which was once the go-to choice for an Omaha-based investor who wishes to remain unnamed.
Analyze Past Results to Estimate Future Potential
You can estimate a company’s value using a cocktail napkin, pen, and key facts. Write down the company’s current earnings and divide by the interest rate of safe investments like treasury bonds or bank certificates of deposit. This provides an estimate of book value or intrinsic value that is often alarmingly close to what a more complicated analysis would reveal.
In our example, if the firm made $1 per share and we divide that number by 5 to get the anticipated return on a CD (5 percent, or .05), we arrive at $20, which indicates the company’s inherent worth. If the stock trades for more than $30 or $40 per share, it would not be a bargain under our Fallen Angels approach.
It is rational for value investors to search for cheaper stocks, even when the company is doing well and demonstrating growth. This is because prices go up and down based on events, public feelings, business cycles, etc.
To continue the analysis, look at factors such as estimated future cash flow and earnings, which are both reduced to present values. Then compare those numbers to come up with a total market capitalization for the company. In other words, this is simply the value placed on the company by the investing public. The value analysis would also include items like the company’s debt and contingent liabilities.
Remember, even if you analyze something carefully, neither the simple nor complex method can tell you what will happen in the future. Both methods only use past performance to try and estimate future returns.
That said, I am adamant that only firms with a proven track record of earnings growth are worth investing in. That is why earnings growth is the first criterion on our list of 13 things to look for when researching a stock for purchase. If you’re perplexed by a word or phrase, I recommend you search it, and hundreds of definitions and examples may be found on the web.
Here’s a list of questions to ask yourself when deciding on an investment strategy.
A company’s history is important to observe when making investments. Look for a company that has grown its earnings consistently and will most likely continue doing so in the next 3-5 years. Also, ensure you feel confident enough to predict that the shareholders’ equity will grow at a 12% annual pace.
The company’s revenues and earnings.
- Are they increasing?
- How do the current fiscal year numbers compare to last year, and what are forward-looking estimates?
- What do demographic studies indicate about future demand for the company’s products or services?
The price-to-sales ratio and price-to-earnings ratios are two other valuation measures that we consider. We prefer firms with relatively low price-to-sales and price-to-earnings ratios as valuation measures. Understanding why a company trades at a low multiple is crucial to this analysis. A firm’s stock may often be declining for valid reasons.
Historically sound businesses that have recently gone through a recoverable calamity or temporary setback but remain fundamentally and qualitatively strong and are thus out of favor with Wall Street for no apparent reason appeal to us.
As an example, consider two firms in the same industry. The P/E ratio of Firm A is 20, whereas the P/E ratio of Firm B is 10. Firm B’s price-to-earnings (P/E) growth (PEG) ratio is greater than 1; therefore, it may be undervalued. PEG has been a valuable tool for determining entry points into value stocks in expanding businesses in previous decades.
Return on equity. The company’s return on equity is one of the best indicators of management effectiveness and ability to create value for a corporation. (Historically, around 12% has been typical for American firms.) How does the firm’s current return on equity compared to its historical returns?
As mentioned, free cash flow is essential when assessing a company’s financial health. Simply put, free cash flow is the cash generated from operations, less the capital expenditures and other investments necessary to sustain and grow the business.
Companies that generate positive free cash flow can use the money to retire debt, repurchase stock, pay dividends, and buy new businesses that enhance the value and strategic strength of the company. In other words, they have more money than they need. These are the “Darwinian Darlings,” the fittest companies that can survive an economic downturn.
Is Conservative financing a company that is conservative with its financing?
Is the company’s debt level reasonable, given the current circumstances?
Is the company’s current ratio greater than its short-term liquidity? Is the company’s current assets (cash and assets readily convertible to cash) greater than its current liabilities by a significant amount? Why not?
Is the firm’s net profit margin better or worse than its competitors?
The concept of intrinsic value calculations is important to include in your valuation approach. This concept is based on the belief that all investments have an inherent value which market prices vacillate around. Often, a stock will trade below or above its actual value due to current economic conditions, the cyclical sector it’s in, or even if there was a recoverable calamity recently.
We believe stock prices should eventually go back up to meet their actual or intrinsic value because nothing is temporary. We use different methods to discover the intrinsic value, depending on what kind of company it is, its dividend policy, and the industry it competes with. And we only invest in stocks that we think are excellent companies but are currently undervalued–we look for a discount of 25-50%.
Is there a chance that the firm’s management talent will develop and profitably utilize retained earnings and other resources?
Two important factors to consider when researching a company are honesty and competency. You want to ensure that the show’s people seem trustworthy and have shareholders’ best interests at heart. It’s also key that their financial interests align with public shareholders and that they own stock in the company. Lastly, ensure that compensation is reasonable across board positions within the organization. Finally, read the company’s reports and financial statements carefully to understand where they stand financially as an institution.
Is management taking the time to understand your needs and wants? What kinds of customer support or information do they provide? Is it possible to contact someone who will listen to you and respond appropriately? Are they interested in their customers, product quality, service excellence, or other aspects of the business that are important to them? Are they committed to improving this aspect of their business significantly over a period of time so that it becomes exceptional on all levels? -> Is there leadership in the field? Is the firm a trendsetter in its industry, consistently bringing new items, services, and ideas to market?
The Market Always Knows More Than Any Individual
More often than not, a company’s stock price says more about its future prospects than any analyst report. Fundamental research is important, but if you want to get an edge on the market, it pays to learn basic chart reading skills (a.k.a technical analysis). We’ll discuss this topic in greater detail later on.
No matter how thoroughly you get your investment prospects, factors unrelated to the company can impact its success.
The most troubling is when top officials engage in fraudulent or criminal activity. While there have been a number of high-profile cases in recent years, more common are those that have managed to stay legitimate while still fleecing shareholders and creditors.
These executives not only deceived the public through legal but questionable accounting practices but also managed to sell their stock before it hit rock bottom. In doing so, they captured large profits for themselves. For example, insurance behemoth AIG is a company that appears to have concealed many of its problems from investors’ prying eyes.
Although its share price had decreased for many months, the firm’s stock plummeted to $1.25 in September 2008 after running out of cash due to the subprime mortgage crisis. The US Treasury came to the company’s rescue and acquired a nearly 80 percent stake, putting up more than $100 billion in taxpayer money. You’d think pensioners, investors, and taxpayers who have lost most of their money would be brandishing pitchforks… But they aren’t.
Gossip on the Marketplace
I use these examples to point out that markets are frequently aware of such risks long before they become news. Investors may detect trouble brewing in the market’s sentiments toward specific equities if they pay attention to the market’s attitude towards them.
Markets of all kinds have been hotspots for rumors and scuttlebutt for thousands of years, some of it true but much less than trustworthy. However, because secrets are difficult to keep and transparency is often the game’s name, the flow of information in and around the stock market can be beneficial.
In the case of AIG, and so many other firms, the market sensed problems before they were made official, causing stock prices to fall and ostensibly providing investors who were paying attention a strong indication signal and enough time to sell their AIG stock beforehand. The basic evaluation of AIG was worsening, as evidenced by some of their public disclosures.
Even after you’ve decided to purchase a company, it’s still essential that you keep track of the company’s progress. This is done by monitoring revenue decline, return on equity (ROE), and other key indicators. If these are all decreasing, it might be time to sell- even if you haven’t hit your target price.
Stay Away From Companies That Have Fallen and True Believers
Even after 5,000 years, gold is still valuable. You could purchase 350 loaves of bread with only one ounce of gold.
As companies sometimes fall from glory, we mustn’t forget that letting go and not sink with the ship is okay. In his book Hedgehogging, Barton Biggs covers how some people hold onto incorrect assumptions.
He uses gold as an example of something society has revered for centuries—not only because of its value but also due to its mystical properties supposedly keeping it valuable. Although gold has positive connotations, such as maintaining power throughout the years, we can’t forget the negatives.
Biggs explained that, based on the Old Testament, more than 2,000 years ago, one could purchase 350 loaves of bread with only one ounce of gold. Gold is such a stagnant investment that its real value has not increased for thousands of years! In today’s economy, an American can still buy approximately 350 loaves of man breeds with just one ounce of gold. Astonishingly, over the past hundred years, commodities have appreciated ten times more than the value of gold!
According to Biggs, becoming a “true believer” is one of the most common traps that investors can fall into, whether it’s a precious metal, a commodity like oil, or any other stock. The greatest investors listen to what the market has to say.
The Contrarian Stance
Even though the market does some things quite well, there are times when it is best to ignore it. I’ll give you an example from another experienced Wall Street trader who wrote a book in the 1940s about investing.
The author of the book was Fred Schwed, Jr, and it is called “Where Are the Customers’ Yachts?: or A Good Hard Look at Wall Street.”
According to Schwed, investors should shift their money from stocks to bonds and back again when the market becomes overly exuberant in either direction. He stated that when the market reaches manic heights, with individuals rushing to buy stocks at any price and newspapers touting how much money can be made, investors should sell their stocks and invest in bonds.
Without a doubt, stocks will continue to surge upwards; however, Schwed urges investors to pay no attention to the trends and wait for the eventual market crash. When this does occur, and the news is full of dire predictions, nobody will want stocks; that’s when you should sell your bonds and buy them. This pattern repeats itself numerous times throughout an investor’s career–anyone following Schwed’s tips is bound to become very wealthy indeed.
The book’s title was inspired by an event when Schwed, who was training to become a broker, was invited by his boss to lunch at a yacht club. His manager pointed out the various yachts owned by successful brokers, and someone asked where the customers’ yachts were docked. It became apparent that none of the yachts belonged to customers.
The important thing Schwed learned from it was that human nature-not to mention broker misinformation-is what keeps most investors from achieving their financial goals. People want to invest in things that have increased and then sell following a severe decline. Schwed’s timeless advice to take advantage of market cycles is known as counterintuitive investing today, and it’s at the heart of the Fallen Angels approach.
A List of Fallen Angels
Many people will be brought down from their current status, and many currently held in high esteem will fall.
During 2008-2009, investors experienced consternation and panic due to the negative headlines. “Crash,” “stock market plunge,” and “Dow in free fall” caused many individuals and institutions to issue sell orders.
However, to value investors, the market crash wasn’t a tragedy–it was an opportunity. They knew there would be amazing deals n rare circumstances like this if they looked hard enough. So we went through all of the fallen stocks and businesses, looking for the best bargains possible among them.
Discouraged investors selling at a discount through no fault of their own is one of the three forces that create Fallen Angels – and, for my money, the most powerful. Following a panic like the one that engulfed the markets in 2008, many excellent firms with good prospects ultimately sold out at a loss due to a lack of discipline on the part of investors.
All an investor needed was fortitude, a strategy for purchasing when others were selling, insight into stocks with future development potential, and perseverance to stay invested until growth returns.
The stock market and the individuals and organizations that make it up adapt to shifting tides. The fortunes of the stock market, as well as those of its participants, change with each tide. In late 2008, an intriguing nugget went viral on the Internet to demonstrate how much a solid financial institution’s value might fluctuate in a single year.
In 2007, the Royal Bank of Scotland bought ABN-AMRO, an Amsterdam-based bank, for about $100 billion. Only a year later, when the global financial crisis and the collapse of numerous institutions occurred, that same $100 billion would have purchased these banks and brokerage houses: Citibank ($22.5 billion), Morgan Stanley ($10.5 billion), Goldman Sachs ($21 billion), Merrill Lynch ($12.3 billion), Deutsche Bank ($13 million), and Barclays ($12.7 billion). There would have been a few trillion dollars left over, enough to acquire one or more of the Big Three automobile manufacturers in the United States.
Not all firms, such as the Detroit automobile factories, are expected to survive the financial crisis, so they can’t all be considered Fallen Angels. However, if we perform a thorough examination, we will discover discolored gems hidden among the wreckage of the 2008 financial crisis. During the sell-off, many of the world’s top financial institutions’ shares fell considerably as well as other stocks in the market.
We can call it “great moments in bottom fishing” when we buy excellent companies on sale and hold their stocks until they reach or exceed their former highs. What follows are some of the most dramatic examples of “Fallen Angels” that rose again to glory, sometimes more than once.
The Mickey Mouse Company With Faulty Accounting
Walt Disney Co. was hard hit in the early 1980s and had been ailing ever since. The stock had been trading at around $30 per share for many years before hitting an all-time low of $73 per share. After decades of success on the back of its creator and namesake’s beloved characters, the firm was on the verge of bankruptcy.
Though the firm had gone through its share of highs and lows due to Walt’s propensity for taking chances and betting the farm on projects like his idea for a Disneyland theme park, it was going through one of its toughest periods.
By the mid-1980s, however, despite the continued popularity of Disneyland and other Disney properties, mismanagement resulted in significant overhead costs and few profits, jeopardizing investors’ investments.
In the 1980s, greenmailers became a common occurrence. These were groups of investors who would buy up the stock in struggling companies and then demand that the company either buy back the stock at an inflated price or watch as the greenmailers used their voting power to oust management and the board of directors.
This tactic was successful for many greenmailers, but company boards came up with a countermeasure called the poison pill. The poison pill is a set of actions that makes a company unappealing as a takeover target (such as dispersing cash reserves through a special dividend).
After the disappointing performance of previous Disney directors, Michael Eisner was hired to turn the company around. Eisner came in with a plan to reorganize and streamline Disney’s various media holdings. This included purchasing other companies, such as the ABC television network, and fostering integration between the company’s different brands. This allowed for cross-promotion of Disney’s music, movies, and entertainment properties.
Those who bought Disney stocks in 1984 near the bottom price would have had a good 16-year investment until it reached $41.
A Group of Yahoos
In 2002, the Internet celebrity Yahoo! fell to $4.05 a share following a peak of $108 just two years prior.
Yahoo! was a successful company that built its business around a successful search engine. However, after the dot-com bubble burst, its stock prices deflated. But Yahoo! was not slacking; its revenue continued to grow, and its brand improved.
Overall, Yahoo!’s business prospects were bright. Because its stock price had dropped below what it was intrinsically worth, Yahoo became a “Fallen Angel” and thus an attractive investment for those with keen eyesight.
In late 2005, just three years after dropping to its low of $4.05 per share, the stock recovered nicely and was trading at $43 per share. However, as has been the case with many Fallen Angels, Yahoo!’s stock has gone through numerous cycles of booming and busting in accordance with business and market cycles.
In recent years, the stock traded at around $12 per share as Yahoo! struggled due to weak management and poor advertising sales. As things currently stand, it is uncertain whether or not Yahoo! will retain its status as a Fallen Angel.
Jack Finds Himself in a Jam
In 1993, the Jack-in-the-Box restaurant chain found itself in the midst of a horror scenario after an outbreak of foodborne illness was traced to Jack-in-the-Box hamburgers. Four children died, and hundreds of people became ill during the epidemic, which occurred in the Pacific Northwest.
The restaurant’s failure to cook its burgers to a high enough temperature helped contribute to the occurrence.
Jack-in-the-Box’s stock reached an all-time low of $2.06 after the E. coli outbreak but quickly recovered due to strong fundamentals. Those who invested in the company were rewarded with a 14-year price increase from 2001 to 2007, reaching $38 per share.
The problem was overcome using a combination of strategies, including new food safety and quality control measures, financial compensation to the victim’s families, and an aggressive marketing campaign.
The Jack-in-the-Box incident demonstrates how a recoverable catastrophe can temporarily depress a company’s stock price, making it an investment possibility for those willing and able to recognize the business’s potential and take action on that knowledge.
Additional Fallen Angels
Many excellent firms fell into the realm of Fallen Angels in 2000 due to the technology wreck. Qualcomm was one of the most well-known companies to succumb to this fate. The price of Qualcomm stock plummeted from $88 to $13.71 in 2002, making it an excellent investment opportunity for people who knew what they were doing.
Within four years, the stock rebounded and went above $51; nevertheless, it has experienced its ups and downs with the market over time. Of course, it still goes up and down with the market nowadays, but those who bought Qualcomm stock in 2002 have no regrets.
Even blue-chip companies that have a monopoly in their market are not safe from the stock market’s volatility. Southern California Edison, an electric utility company, is an excellent example. In 2002, SCE’s shares dipped to $7.50 per share. However, since 13 million customers kept paying their bills, investors thought better of it, and the stock rebounded back up to $49 within only three years.
Apple’s success story is one of the most captivating tales in recent times. What started as a computer company turned into a digital music pioneer, and now its signs of success are present everywhere you look. Not only does Apple dominate the market with iPod ads and their iconic logo, but other manufacturers are scrambling to design docking stations, speakers, and other accessories that work specifically for iPods.
In 2007, Apple announced the 100 millionth iPod sale- which is no small feat considering each device costs between $200-$300.
But it wasn’t always thus. In 1997, Apple stock was put on the market at $3.28 per share, following pressure from arch-rival Microsoft. It climbed to $21 by 2000, then dropped to $7 in 2003. With its stock peaking at $198 in 2007, the iPod pushed Apple into hyperdrive.
Apple’s turnaround resulted from deliberate management efforts to reinvent the firm from an also-ran computer manufacturer into a trendy, stylish, cutting-edge business force. Apple’s core following of devoted techies was insufficient to keep it in the black.
In the late 1990s, Apple was facing its darkest days. Some shareholders called for the company to distribute its cash and fold the shop. If they had followed this plan, each shareholder would have received $6 per share against a stock price of just over $3. But Steve Jobs and other Apple executives had other ideas.
Fallen Angels: The Risks and Benefits
Apple was one of the riskier turnarounds plays among the examples I have cited, as its success depended on new products and services. However, Apple triumphed, returning to profitability and expanding its future horizons.
It also provided a much-needed boost for digital content producers by creating new product markets. What made the stock attractive was the abundance of cash on its balance sheet, which management had set aside during Apple’s prior glory days.
“Rags-to-riches stories are always inspiring, and Research in Motion’s (RIM) journey is no different. The company behind BlackBerry saw its stock plummet to $1.46 per share in 2000 after trading at $24 just a few months earlier. However, over the next eight years, RIM’s fortunes changed for the better, and by 2008 its stock had reached an all-time high of $132 per share.
RIM was a much stronger Fallen Angel candidate than Apple because it had a primary product and did not need to invent one. Jack-in-the-Box was another low-risk Fallen Angel because it needed to recover from a one-time calamity, which it accomplished.
Qualcomm and Disney are both companies that have had great success in their respective industries. Qualcomm has been a leader in wireless telephone technology, while Disney has a long history of producing popular films and characters.
In recent years, both companies have faced challenges threatening their profitability. For Qualcomm, this has come in the form of increased competition from other companies such as Huawei. For Disney, the challenge has been finding a way to appeal to new audiences while maintaining its core customer base.
Fortunately, both companies have made the necessary adjustments to remain successful. In Qualcomm’s case, this has involved focusing on new product development and expanding its customer base. For Disney, the key has been diversifying its business portfolio.
When it comes to public companies, there are a few key indicators that investors look for before deciding to buy or sell shares. One of the most important factors is the predictability of future revenue streams. For example, if a company’s sales largely depend on consumer spending, investors will be more cautious about investing in that company during an economic downturn.
Another critical factor is the likelihood of continued growth. If a company is expected to maintain its current level of development, then it will be more attractive to investors than one that is not growing as rapidly. Finally, investors also tend to favor companies with businesses they can understand.
The tech bubble burst in the early 2000s hit many companies, including Yahoo! and Qualcomm. Both were forced to make significant cuts and saw their stock prices plummet.
Similarly, Apple and Jack-in-the-Box were both affected by one-time calamities.
Apple was struggling to find its following big product after the success of the iPod, and Jack-in-the-Box was dealing with the fallout from an E. coli outbreak. Both companies saw their stock prices fall as a result.
Finally, Disney was hit by a market panic when it became clear that its business model was not sustainable. This led to a sharp decline in its stock price.
After some rocky periods, these stocks rebounded – which wasn’t entirely shocking because they had stable business models, revenue streams, low debt, and the potential for future growth (except for Apple).
The Other Fallen Angel Opportunity in Real Estate
“Buy land; they’re not making it anymore.” – Mark Twain
Every modern-day recession can be traced to irresponsible and excessive debt creation. Since the invention of credit during the reign of Hammurabi, King of Babylon, around 1792 B.C., leverage has aided and damaged investors.
Twain’s recommendation to invest in real estate may have seemed sound at the time, but it couldn’t save him from bankruptcy. During the debt-fueled Panic of 1894, Mark Twain lost almost everything.
Discounted Single-Family Homes
Investors often overlook the abandoned property, but it can be a goldmine for those willing to do their homework. With a bit of research, you can find properties selling well below replacement value.
Of course, the abandoned property comes with its own set of challenges. You’ll need to be aware of local laws and regulations and any potential safety concerns. But if you’re willing to work, the abandoned property can be an excellent opportunity to make money in real estate.
Investors often take the conventional route and go through a Realtor when starting. They soon learn that investing is a highly competitive endeavor. Review the listings, and if you find a great property at a great price, you will suddenly discover that there are already five or more offers on the same property.
As a result, the price increases, or the terms may call for an all-cash purchase at a premium. In this familiar scenario, you’re competing with motivated buyers. Just like the stock market, the real bargains in real estate come from motivated sellers.
Unusual Advice: There Is Little or No Competition for Property That Has Been Abandoned
Abandoned single-family homes in the middle- and lower-middle-class neighborhoods have boarded-up windows, surrounded by dying lawns and overgrown weeds. No Realtor can rent them, and no one wants them.
The owners or the banks are desperate to unload them and are unwilling or unable to spend the time or money to improve them. The real estate road less traveled is exactly where the Fallen Angels are.
Before we discuss a methodology for buying and selling distressed single-family homes, however, I think it’s important to review a familiar cycle.
The Real Estate Market’s 18-Year Cycle
I know this may sound like numerology, but whatever the reasons, real estate prices have followed an 18-year cycle in the United States for more than 100 years. Generally, we get nine rising years, followed by nine years of contraction.
This has undoubtedly been the pattern in my lifetime. I’ve seen this real estate wheel of fortune turn several times now, and I agree that a declining market offers the best chance you may ever have to accumulate significant wealth over time. It’s been so long on Wall Street and Main Street.
The business cycle has a major impact on the real estate market, as economic expansions and contractions affect demand for housing. When the economy is doing well, there is typically more demand for housing, driving up prices. However, fewer people buy homes when the economy slows down, and fees may drop.
Dewey was the agency’s chief economic analyst. He was commissioned to discover how a great and prosperous nation could suddenly have been reduced to soup lines with former executives selling apples on street corners.
He dedicated the remaining 40 years of his life to studying cycles, both in nature and business. Dewey believed that people and their institutions were subject to many of the same influences found in nature. In his search for answers, Dewey turned to the study of cycles.
Many people, throughout history and presently, have debated the correlation between business cycles and the seven-year locust cycle or eleven-year sunspot cycle.
We are not confident in either argument, but we know that the nine-year expansion of credit and real estate values began in 1996 and ended precisely nine years later in 2005. Only time will tell us for sure, but if we use history as an estimator, housing prices will rise again around 2013 or 2014.
Where and How to Locate Abandoned Property
Slumlords are derogatory terms for absentee owners who attempt to maximize income by reducing property upkeep. This is not a good idea for purchasing single-family homes at Fallen Angel.
It’s an eyesore when you buy a run-down home, but once it’s yours, the main goal is to make it livable again, making it a desirable property for potential house buyers or renters. You’ll be giving additional services to your community beyond the obvious financial benefits to yourself by getting these houses clean.
Familiarize yourself with the neighborhoods in your area where foreclosures have occurred most. Signs or notices placed by the front door should be simple enough to identify who the bank or lender is from. Putting a tiny classified ad online and in several neighborhood papers could be an excellent technique for shaking the peaches off the tree branches.
Real Estate’s Optimal Price-to-Earnings Ratio
Humans are subject to tremendous emotional swings. We’re affected by economic situations, and cyclical forces that we can’t see, such as those Dewey observed in nature. Value is a moving target. Nobody knows what constitutes the best bargain, one in which value and price are perfectly balanced.
Eventually, when another potential buyer appears on the scene and makes us an offer, something that happens millions of times every day in the stock market.
When prices are transparent and constantly changing, it’s easy to see when the public believes stocks are reasonably valued. When sentiment is positive, and the economy is expanding, prices increase. Even “value investors” adjust their price-earnings assumptions based on mood changes. Real estate behaves similarly in this respect.
The rule of 15 is a popular metric that real estate agents have used for many years to determine the fair value of a house. With this method, the worth of a property is based on its potential rental income. If you own a house that could be rented out for $2000 per month, or $24 000 per year, then using the rule of 15 would give your home a fair price tag of $360 000.
In real estate, bear market rents and values will drop. From my experience, buying a house at 15 times its gross rental revenue is a great deal. To put this into perspective, if the Gross Rental Revenue is $24,000, it would cost $360,000. This way of thinking about purchasing property is typically called a capitalization rate- where you take what you expect to gain from owning said property free and clear.
Of course, there are taxes and upkeep expenses to consider; they are essential. Use net (after-expenses) rental income times 15 (or lower) in your bids if you want to be cautious. When houses sell above 15 times gross rental income, they have historically been overpriced. Housing prices are influenced by value and momentum, much like stock values.
Value vs Momentum
The law of demand, also known as Newton’s Law, is true for property and the stock market. The main distinction is that because homes and real estate are more challenging to acquire and sell, transactions take longer. As a result, prices will move up or down in an unclear manner. Weeks, even months, may pass before properties are transferred in a strong real estate market.
When houses in your neighborhood were traded on a public market, with prices fluctuating daily as purchasers and sellers swapped pieces, our viewpoint about home values would swiftly shift. When a tornado, flood, fire, or earthquake hit the area, you’d observe home prices plummeting just as fast as stock markets do when bad news arrives.
If recent numbers on local employment or population growth revealed a housing shortage with increasing rents, house values would rise like stocks do when there’s good economic data.
Like everything in the universe, value and momentum are essential in stocks, gold, real estate, or currency.
One of the great debates in active (as opposed to passive buy and hold) portfolio management is the battle between value and momentum. Which approach is best? The short answer is whichever one performed better in the past. I suggest you use value and momentum analysis whenever you venture into the public or private (real estate) markets.
They both have merit, and here’s why:
When a company’s shares trade at a price below fair value or replacement value, they are trading at a discount. The current direction of prices may not reflect replacement values for stocks like real estate.
Real estate is unique because it can’t be immediately sold like stocks. This means that we have to analyze value and momentum a bit differently than with public markets. For example, let’s say an investor buys a stock at $30 because he believes it’s undervalued. He then loves the same stock when its price drops to $20. However, if the stock falls even further to $10, the true value disciple would feel blessed, as this presents an amazing opportunity to buy more before others realize how cheap it has become.
In a stable market, solvency is not typically an issue for real estate investors. However, banks, builders, and homeowners may have difficulty staying afloat in a declining market. These markets move slowly, and when prices fall significantly below replacement values, there is often little to no financing available. Investors typically make the most significant fortunes in these types of markets; that’s why we include real estate as one of “the other fallen angels.
When we Momentum Invest, we invest in assets that have had positive price movements recently. We don’t think about if it’s “fair,” just if the trend continues. So, if prices have been going up or down lately, and that looks like it will continue – even picking up speed – then we invest. People who follow trends only buy when prices are already rising because they expect the market to keep going that way and sell as soon as prices start falling again.
As prices continually rise, a domino effect is created where banks, builders, and homeowners become overconfident. This eventually leads to complacency as loans become easy to obtain due to appraisals being based on recent sales of properties at the highest prices. Buyers assume they’ve made instant equity, allowing momentum to feed on itself until starting a new debt cycle.
What Is Value Investing and How Does It Work?
There are many ways to determine the value of a business, real estate, or anything else. Two common measures include statistical cheapness and historic mean pricing. Statistical cheapness compares where a stock, index, or asset class is trading relative to its historical mean price. This allows you to see if it is currently underpriced or overpriced based on its underlying value.
The second approach we term bottom-up fundamental analysis. We’re discounting projected future cash flows because we can’t be sure the firm will be profitable in the future.
It is difficult to predict the future, especially regarding rental property. However, bottom-up fundamental analysis can help you estimate a fair value for shares of a company or the price of a rental property. If the stock or building is trading at a discount to this fair value estimate (referred to by value investor types as a margin of safety), it may be worth considering as an investment. Generally, this method of investing gives little thought to momentum.
In most cases, stocks and property that fulfill the established standards will frequently deteriorate from undervalued to severely undervalued; what your study determined was cheap becomes far less expensive.
This negative price momentum might be disheartening and painful for investors who own assets with prices updated daily. The investments were shunned, and their values were declining. Momentum was down, which is why they traded at a discount in the first place. The same psychology applies to real estate, albeit with a slower wheel of fortune.
We call investment opportunities that have declined in value below their underlying worth “Fallen Angels.” If you buy them at a low enough price, they can be safe investments since they are currently priced significantly lower than what is deemed fair.
Value investors who purchase these assets at a discount and wait until the market prices catch up to the actual value often make large profits. No trend ever lasts forever, but most last longer than people anticipate–patience is key.
The Most Significant Obstacles of Value Investing
To discount future cash flows, you must predict what those cash flows will be in the future. These assessments (also known as “guesstimates”) consider factors like what management will spend on capital projects, such as the tax rate for the company and how quickly sales will grow. Inflation, local employment, and what people can afford to pay in the future are all taken into account when making real estate predictions.
Even if your analysis is correct, the “market” may not agree with you for a long time. Let’s say that you believe Company A to be worth $100, which currently trades at $75. That’s a nice 25 percent discount off of your fair-value estimate.
If price and value converge in one year, you’ll have earned a 33 percent return. If it takes five years for price and value to converge, your annual rate of return is 6.6 percent, which isn’t even an optimistic number before taxes and inflation when considering the risks involved with stock ownership. Carrying costs, such as taxes, maintenance, and vacancies, might reduce your total real estate return rate. All of these ideas are valid.
The Momentum Investing Process
In short, momentum investing is less concerned with a stock’s fair value and more focused on whether the price is increasing. The source of return, in this case, isn’t the convergence of price and value; it’s simply the hope that trends will continue to develop.
Will those rising or declining investments continue moving in the same direction? Momentum investing believes that if a trend is your friend, it’ll stay that way until it ends.
Key Challenges of Momentum Investing
Making predictions about the future is necessary: Momentum and relative strength investors, in general, use present market data (prices, volume, flow of funds, etc.) to make forecasts about the security’s future price direction and industry. Anyone who invests in real estate because it has appreciated in value is attempting to predict the future.
Has no clear exit strategy: While most momentum investors will generally employ a stop-loss approach to protect themselves from significant losses, stop-losses are prone to whipsaw. It’s tough to sell when prices are trending down because buyers vanish. Stop-losses in real estate might be difficult, if not impossible.
Bubbles are common: Every bubble in history has originated because investors disregarded a rational, fundamental viewpoint of value in the search for large returns from assets that had performed well. Stock and real-estate bubbles are two excellent examples.
Blending Value and Momentum
In the world of active and professional money management, you’ll encounter a lot of “true believer-ism” and close-mindedness regarding investing strategies.
The value crowd tends to deride the idea of momentum or trend following as reading tea leaves (though some of the greatest fortunes have been made here). In contrast, momentum investors see value types as wasting their time with balance sheets and income statements.
They change the locks when you believe you’ve discovered the secret to success.
Unfortunately, there is no such thing as a holy investment grail. When seeking Fallen Angels, I recommend you try to be both a value and momentum investor. Use the momentum toolbox to assist with some of the problems associated with purchasing bargains.
Momentum investors may benefit from utilizing timing tools like those mentioned above to avoid time value traps. The momentum crowd would also profit from reflecting on factors like corporate value and margin of safety before putting resources into a hot stock or overheated commodity.
Newton’s Laws of Motion
Like real estate, the stock market is based on value and momentum. Momentum is at the top of everyone’s thoughts when the market is on a roll. Investors appear to be stuck in analysis paralysis during bear market downturns.
Newton’s First Law of Motion is the tendency of an object in a state of uniform motion to keep moving unless subjected to an external force, as with friction or air resistance. An object in motion has the momentum to continue going; nevertheless, it will eventually come to a halt.
The net force on an object of constant mass is proportional to the magnitude of its linear momentum change over time. In other words, the net force on a body is equal to the mass of the object times its acceleration. Newton’s Third Law applies to the influence a pair of bodies has on each other. If Body A wields force on another, Body B simultaneously wields an equally correlated force on itself. Every action has an equal and opposite reaction.
The first sentence we included in our book comes from Mike Moore’s assertion that “investing isn’t rocket science; it’s harder and more complicated.” Successful investors cultivate a sixth sense of anticipating the consequences of human emotions on the financial markets.
In hindsight, they watch and act upon what looks to be simply predictable crowd behavior.
You can also be successful if you enjoy the journey and find new opportunities. I would recommend keeping an open mind to everything that could potentially move markets.
Try learning how to read a balance sheet and charts and understand technical analysis. Combining value and momentum could be helpful strategies in your toolbox for success.
Ten Fallen Angels for the Next Five Years
The essence of a Fallen Angel is its intrinsic value. Fallen Angels are not necessarily bad investments but often lack the fundamental characteristics that make other companies attractive investments.
We have defined quality in previous chapters to encompass several factors, including quantitative metrics like balance sheet strength and consistency of return on equity and qualitative strengths like competitive advantage and management strength.
The history of financial markets is littered with examples of high-quality companies that temporarily became “fallen angels” companies that ultimately recovered and exceeded prior performance levels. Several well-known examples include Coca-Cola in the early 1980s, Wells Fargo in 1990, and Apple in 2002. Investors buying at depressed levels during these periods earn above-average rates of return on their investments for years to come.
It’s important to note that quality isn’t just the purview of large, well-established companies. Smaller emerging growth companies can also be an excellent place to look for fallen angels. Since large publicly traded companies are widely followed by analysts, owned by institutional investors, and have enormous share float, it generally takes an extreme event like a market panic or industry-specific calamity to depress shares to fallen angel prices.
Smaller businesses tend to have less analyst coverage, are less widely owned, and have issued less stock. As a result, shares in these businesses tend to experience more price volatility than larger companies.
The financial market experienced one of the most significant bear-market sell-offs in history in 2008-2009. We view this type of panic as one of the most powerful forces that can create fallen angels. Conscientious bargain hunters will do well to recognize the enormous opportunity provided by the current market’s sell-off. Below, we have compiled a list of ten fallen angels for the next five years: five larger blue chip companies and five smaller businesses (market capitalization).
This book was written in 2009, so it does not address the current market climate. However, if you are reading this book after 2014, chances are excellent that markets are shifting again. The list below should be viewed not as a recommendation but simply to illustrate the importance of both price and quality when selecting a basket of stocks for a five-year holding period.
Cheap and timely securities (CATS) are what we’re after, and in just about every market cycle, you can find ten to hold for five years. Here are ten that made sense in 2009:
Five Blue Chip Fallen Angels
- General Dynamics (GD)
General Dynamics’ stock price has declined by 54 percent from its 2008 high, making it a compelling long-term value opportunity for investors. The company has a history of generating high rates of return on shareholder equity, and it is conservatively financed.
- Google (GOOG)
Google’s stock has fallen 52 percent from its 2007 high, but the company still has a pristine balance sheet with no debt. Revenue and profits have been in the mid-20 percent range over the past several years, while returns on shareholder equity average about 18 percent.
- Jacobs Engineering (JEC)
Jacobs construction and engineering businesses have dropped 58 percent from their high in 2008. With little debt on the balance sheet, a history of generating strong returns on shareholder equity, and a shift into infrastructure projects as the business cycle shifts from contraction to expansion phase, Jacobs is well-positioned to benefit from growth in the coming years.
- Johnson & Johnson (JNJ)
Johnson & Johnson is down 27 percent from its 2008 high, but it still offers investors a reasonably conservative way to play an eventual healthcare turnaround. The company has long demonstrated the ability to grow book value and consistently provide returns on shareholder equity greater than 25 percent annually.
- Visa (V)
Visa’s stock price has fallen 38% from its 2008 peak due to an image problem: Most consumers know them as credit card issuers, exposed to financial risks facing other card issuers during a severe economic contraction. In reality, Visa is a payment-processing firm with significantly less exposure to economic contraction. The company generates net profit margins north of 20%, has very little long-term debt, and holds a leading industry position.
Five Smaller Company Fallen Angels
- Hansen Natural (HANS), a producer of natural soft drinks, has lost almost 50 percent of its value since reaching its 2007 peak.
- Skechers Inc. (SKX), a company that makes shoes, fell more than 75 percent from its 2008 high and has yet to post an annual profit.
- World Fuel Services Corp (INT) has fallen more than 30 percent from its former highs.
- Mov., Inc. (MOVE) has lost more than 90 percent of its value since its initial public offering in 2000.
- Lineare Holdings (LNCR) has fallen 50 percent from previous highs, as the company’s home health care services have suffered from declining demand.
There are a wide variety of Fallen Angels available for investment, regardless of the current market conditions. By carefully analyzing both the financial health and future prospects of a company, you can identify Fallen Angels that may provide significant returns over the long term.
It can be found in every market cycle, and they offer investors the opportunity to buy quality companies at attractive prices. However, it is important to remember that not all Fallen Angels will be successful investments.
Cheap and timely securities (CATS) are what we are after, and in just about every market cycle, you can find Fallen Angels that have the potential to generate high returns for investors.
In order to maximize your chances for success, it is important to select Fallen Angels that have a history of generating strong returns on shareholder equity and that are conservatively financed.
Fallen Angels offer investors the opportunity to buy quality companies at attractive prices. However, it is important to remember that not all Fallen Angels will be successful investments.
Careful analysis of a company’s financial condition and future prospects is essential to identifying those Fallen Angels that are most likely to generate superior returns.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.