Ugly Stocks With Pretty Returns

 | Dec 17, 2012 | 1:00 PM EST  | Comments
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Stock quotes in this article:

rimm

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fdml

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hpq

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dell

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dmnd

Investment guru Warren Buffett began his career by buying inferior businesses trading at statistically low valuations. This approach was coined the "cigar-butt" investment approach. Regardless of the quality of the business, the price was so attractive, Buffett reasoned, that all one needed was just one free puff from the cigar butt and then it could be discarded. It wasn't until decades later that Buffett made the transition from this short-term investment approach to his preference for buying names like Coca-Cola (KO) and holding them "forever." 

Despite a relatively strong market environment, plenty of stocks that have fallen to cigar-butt status. Prices have dropped so dramatically that these names need nothing more than one good quarterly news report or a change in business sentiment for the prices to pop by 10% or more. Just look at Research In Motion (RIMM), which had fallen to around $6 from more than $60. In the past few weeks, shares have nearly doubled. With the benefit of hindsight, it's easy to tout that RIMM was a screaming buy when it was trading for $6 to $7 and with a well-known investor such as Prem Watsa of Fairfax Financial Holdings as a huge investor.  

Perhaps RIMM would have been an excellent part of a cigar-butt basket of stocks, akin to what Sir John Templeton did back in the 1930s when he bought a $100 worth of every stock trading for less than $1 a share. Templeton quadrupled his money over the next four years. This cigar-butt basket would serve as a meaningful part of an overall portfolio without creating the significant exposure of owning a particular name. An example basket could be a 10% position consisting of five to 10 securities, each representing 1% to 2% of your total portfolio. When a name does well, you can sell it off and either replace it with another or slowly reduce the other positions in the basket. Assuming you make decent picks, such a basket could do exceptionally well.

Carl Icahn's investment in Federal-Mogul (FDML) could be a member of such a basket. This supplier of auto parts once traded for nearly $30 a couple of years ago but now trades for just over $7. The balance sheet is not pretty, with nearly $3 billion in assets and no tangible equity. A market cap of $720 million does give you a business that has increased sales to nearly $7 billion in 2012 from $5.3 billion in 2009. Seeing how Icahn is an equity holder in the company, perhaps he will turn his attention to FDML once his other large activist positions are settled.
Hewlett-Packard (HPQ) would be another excellent addition to the cigar-butt basket, although I would not presume that HPQ is a company with one good puff left. You don't often get titan names that would qualify in such a portfolio. Add Dell (DELL) to that list. Both HPQ and DELL have high-profile investors in Seth Klarman of Baupost and Mason Hawkins of Southeastern Asset Management, respectively.

Diamond Foods (DMND) is another cigar-butt candidate. Trading at $14, Diamond has fallen from above $90 back in 2011. The market is uncertain as it waits for Diamond to report restated financials. If they are better than expected, shares will surge. Even if they don't, Diamond controls popular brands that appear to be worth more than the company's $900 million enterprise value. 

I'm a big fan of the basket approach to investing, especially when it comes to beaten areas like cigar butts or even Japanese stocks. Essentially, you create your own custom-tailored basket of exchange-traded funds in your own portfolio. We have repeatedly seen outsized returns from severely beaten-down names, but we've also seen names drop and continue to do so until the equity gets wiped or severe dilution occurs. With a basket, the home runs more than make up for the strikeouts.

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