Revisiting the Templeton Trade

 | May 04, 2012 | 5:00 PM EDT
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The clan gathered at Chez Melvin last evening for a little wine and cake in celebration of the old man getting older. It was a gorgeous night, so we sat out on the patio enjoying some conversation and my son and I got onto the subject of stocks and the stock market. I am teaching him how to use some basic value techniques and to focus on long shots that can offer dramatic returns over time. He is young enough that he can be much more aggressive in his approach to the markets and focus more on distressed equities with the potential for recovery.

During our conversation, I told him one of my favorite stock market stories. Sir John Templeton borrowed $10,000 before World War II and bought every stock under $1 on the NYSE. Over the next four years, the portfolio of cheap stocks quadrupled in value. It was the beginning of his fortune and spectacular investing career.

This investment strategy can still be done today. I adjust the $1 to $3 to capture more opportunities in low-priced NYSE-listed issues. Listed stocks trading below $1 today are often in danger of losing their listing and moving to the Nasdaq or even the pink sheets. I add an additional rule to the screening process: no Chinese stocks. I do not trust one single number issued by a Chinese company, government agency or other source when it comes to the markets.

I assembled a portfolio of stocks that were trading below $3 on the NYSE back in 2008 when the world was thought to be ending. I have kept track of how it performed and it has actually a little better than Sir John did with his low priced speculation. The portfolio has seen a few bankruptcies, several takeovers and mergers but most of the stocks are still listed today. The return is a nice multiple of 5x the original capital rather than a paltry percentage. It is a high-risk and very volatile trade, but if I were a young man, this fertile arena would be the staple of my investing efforts.

Today, when I run this simple screen, I get a list of 90 names. After a bit of sorting, I found 20 companies based in either China or Hong Kong and moved them to the scrap heap. I did not remove all the non-U.S. companies -- there is a healthy representation of European stocks including Greece, Spain and Italy. Sir John was a pioneer of international value investing, so we need to keep a global flair to our portfolio of cheapies.

There are some intriguing companies on the list. Sprint (S) has struggled to turn its business around, but there are some signs of improvement. The CEO and CFO have both been buying the shares for the past few months and that is usually a predictively bullish indicator for the long term. Sprint is seeing revenue growth and with the addition of the iPhone 4s to its networks, the company is expected to show solid subscriber gains this year. Last quarter, the company added more than a million subscribers, bringing the total up to an all-time high of 56 million users. There is execution and debt risk for this company, but if it pulls off the turnaround, the stock price could easily double or more over a few years.

As you might expect, many banks are on the list of NYSE-listed cheap stocks. One that I find intriguing is Synovus Financial (SNV). This Georgia-based bank, which does business in the southeastern U.S., has been hard hit by bad loans over the past few years. The bank is not completely out of the woods yet and I think it will need more capital before it is all said and done, but its outlook is slowly improving. Nonperforming assets declined by 17%, year-over-year, as management continues to focus on improving asset quality. Core deposits are rising and overall expenses have been declining. If the bank can continue its march toward sustained profitability, the stock could easily move back toward it $3.55 a share tangible book value over the next year. If the bank's loan portfolio continues to improve and it is able to grow tangible book value over the next five years, the stock price could easily triple in that time frame.

These are just two of the almost 70 companies the Templeton screen turned up. Some of these stocks will file bankruptcy and disappear. Some will be merged out of existence or gobbled up by private-equity companies. But if history is any guide, there is a significant chance that aggressive investors who buy all of them will earn a handsome long-term return -- as long as they can stomach the volatility along the way.

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