By Holmes Osborne
How has ever great stock picker made a fortune? At one point in their career, they bought a fallen angel. These are great companies that have fallen from grace, often to the point of trading less than a $1 a share. Buffett did it with GEICO and bought at $2. Do you remember when Krispy Kreme (KKD) was trading for less than $1? It’s now $27. How about Ford (F) at $2?
What are the parameters for making money in fallen angels? The first is to buy at the point where there is very little downside. At $1 or $2 a share, they can’t fall much further. The sheer mathematics is what makes these so attractive. If a $1 stock goes to $10, it can pull the value of your entire portfolio up with it. You are not going to make a fortune buying IBM (IBM) at $100 and selling it for $150. A 50% profit is nice but not enough to smooth out your losers.
The second parameter is that these companies have to stay in business. There can be a multitude of reasons why a company has fallen. Perhaps its industry is out of favor (like gold miners right now). Maybe management has done something untoward. When you buy a fallen angel, imagine what people will be saying in five years. Look at old articles when a stock is a $1 a share. Nothing but bad news.
Examine debt levels and see if the company can maintain bond payments. If they can, these are the types of companies that can turn around. In 2008, I had the good fortune of buying Finish Line (FINL) at less than $2. The markets were worried that a law suit from a failed merger with Genesco (GCO) was going to bring the company down. Finish Line had no debt and companies with no debt rarely go out of business (Circuit City being the exception). I sold at $8. If I’d held on longer, I would have made even more as it was at $30 recently.
When was the time to buy internet stocks? Was it in the late 1990s when they were sky rocketing? No. It was when they crashed and were trading at less then what they had in cash in the bank. Of course, the pundits weren’t telling you to do this. You have to figure this out on your own. Fallen angel investing can be quite lonely at times.
These fallen angels don’t always work out. I remember people buying Washington Mutual at less than $2 a share. Guess what? It went to $0. Don’t put too much in any one issue. There is risk involved.
Remember, stocks that trade less than $5 a share are by definition penny stocks. So at one point in time, Ford and Bank of America (BAC) were penny stocks. If their market caps fall below $500 million, they are considered micro-cap.
Investing in falling angels is an exercise in behavioral finance. It’s being able to buy something when everyone else is running for the door. Brains aren’t always going to help in these situations. A stomach lined with iron will serve you much better.
Typical research doesn’t always help in these situations. Often times, the financials look awful and you are having to look into the future. They can be attractive if they trade at a huge discount to book value or even better, net asset value (the true value of assets minus liabilities). Buying at the right time is key. I bought Pier One (PIR) at $8, gave up, and sold at $5. It bottomed out at $1 and was at $25 not too long ago. Darn. Missed that one.
When markets crash, you can assemble an entire portfolio of fallen angels. 2001 and 2009 gave investors some chances of a lifetime. If we have another big market pullback, you may have another opportunity.
In the mean time, what is on sale? Miners look very interesting. Market Vectors Junior Gold Miners ETF (GDXJ) might be a great investment if you want to diversify. It’s off its 52 week low of $28.82 and is trading at over $34. A look at its holdings shows a lot of producing miners trading in the doldrums. These microcaps are greatly levered to gold: a small movement in the price of gold could portend an enormous jump in the stock prices of miners.
Uranium is another beaten down sector. The disaster in Fukushima, Japan, looked temporary but nuclear power has been out of favor ever since. The Global X Uranium ETF (URA) was trading at $65 just three years ago and is now $14. A look at its holdings shows some great microcaps that are down and out: Energy Resources of Australia (ERA.AX) and Paladin (PDN.AX) both trade in Australia which is one of the top uranium producing countries in the world. Ever hear of buy and hold? How about buy and forget. That might be a better strategy on some of these.
Look at the list of stocks trading at 52 week lows. This is a great place to do some bottom fishing.
The challenge with investing right now is that the market has been on a tear for the last five years. A pull back is going to bring these down even further. Remember when I pointed out how a $1 stock going up can do wonders for your portfolio? A stock going from $2 to $1 can hurt it too. If you like fallen angels, keep your fingers crossed. There may be a fire sale soon.
BIO: Holmes Osborne is the principal of Osborne Global Investors, a money management firm. Holmes holds a bachelor’s in finance from Syracuse University and the Chartered Financial Analyst designation. Holmes has spoken frequently on the topic of the economy and financial markets and previously had a television program on public access. Publications that his articles have appeared in include: The Motley Fool, TheStreet.com, Seeking Alpha, and Investopedia. He was the featured advisor in the April 2013 online edition of the Wall Street Journal. Holmes has also served as an expert witness in court cases involving financial ethics.
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