Try Loving the Unloved

 | Feb 24, 2012 | 1:30 PM EST  | Comments
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I have spent a lot of time this week thinking about some of the greatest investors of the past few decades. I have tried to steal ideas, concepts and philosophies from the investors and traders who have compiled the best track records and learn what made them great.

I do not just take from the value types: I am an equal-opportunity, free-range philosophy  thief when it comes to the markets. I lifted concepts such as "test everything" and "employ skeptical optimism" from individuals who had success in the futures trading arena. The idea of focusing on neglected firms came from a legendary growth investor.

However, the two philosophies that form the core of my philosophy on the markets come from two value investors. Sir John Templeton advised buying at the point of maximum pessimism. Seth Klarman espoused the idea of being the buyer of last resort as path to investment success.

I like to buy stocks when almost no one else does. When I buy a security and associates look at me as though I have lost my mind, then I know I am probably on the right track. In 2009, buying accidental high-yielders that had fallen dramatically in price in a very short period of time was considered financial suicide. Last year, European and Japanese banks were the least loved assets on the planet. Small banks have gotten no love from investors for the better part of the past three years. So, when the broader market universally hates a sector or asset class, I like to break out my toolbox . Valuation is still the most important factor in my decision, but I love buying stocks that trade below book value or at very low enterprise value (EV)/earnings before interest, taxes, depreciations and amortization (EBITDA) ratios and are the stock market equivalent of nuclear waste.

For the most part, this has worked very well. Stocks such as Foot Locker (FL) and Seagate (STX) that had fallen so far that their once incidental dividends became substantial have tripled over the past three years. My foreign bank holding, Royal Bank of Scotland (RBS), has caught a very strong bid so far this year. Even small banks have recently been attracting some investor attention.

Buying asserts on the cheap when no one else wants them is an approach that has worked very well for me. It requires patience and some amount of fortitude as these stocks usually go lower before they turn around. It helps to be a scale buyer of cheap, unloved assets.

I am now starting to see this type of universal dislike in the natural gas and coal sectors. All the investor attention is on the spiraling price of oil and all the political talk about alternative energy sources is about wind and solar energy. We have a glut of natural gas and the weak economy has dampened demand. The talk of converting cars and trucks to cleaner burning natural gas has died down over the past few years and the commodity really has not been part of the conversation about energy alternatives. Coal is just hated by one and by all, as it is by far the dirtiest fuel source we have. It doesn't help that coal mining is also a messy sometimes dangerous business.

It is starting to show in both the stocks and the companies' performances. Two companies I own in the natural gas sector, EXCO Resources (XCO) and new distressed equity purchase Penn Virginia (PVA), recently posted disappointing earnings reports. Both lost money and expect to continue to do so. Both are closing gas drilling operations as a result of the weak pricing environment. Industry leader Chesapeake Energy (CHK) is also reducing its drilling capacity and selling assets to fund their operations. We have a lot of natural gas, but no one seems to want the stuff.

It is even worse for coal. Lower natural gas prices mean the many of its larger customers are converting to gas from coal. Regulatory and political pressure on the industry is hurting demand and margins. Key European markets may want coal but no one in this economy can pay for it, so shipments to those markets are down as well. Cola company earnings reports are coming in and showing lower shipments, lower prices and large losses for the last quarter of 2011. The outlook for much of 2012 is also bleak.

It is probably too early to start buying coal and natural gas companies in size. Prices will probably continue to decline for at least the next six months. However, the stocks are cheap and eventually all the natural gas capacity being taken offline will allow for firmer pricing. Coal demand from Asia and other emerging markets is not going to go away and the merger-and-acquisition activity in the industry is going to create leaner companies with economies of scale. I may have to hold the stocks for several years. but I am used to that. There is going to be serious money made in natural gas and coal stocks as they bottom.

Nobody loves these companies and that attracts me.

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