Behind the Red Door: Finding Value in an Overpriced Market
I am about to write a quarterly letter to clients, telling them that despite all the giddiness in the stock market, we are in Value Investor Second Hell. This is not the first hell; that one is reserved for value traps — stocks that look cheap based on past earnings but whose earnings are about to disappear, whereupon the stocks will permanently decline.
The second hell is when you cannot find value. I recently read a study that said the difference in valuation between the cheapest stocks (the lowest 10 percent of the market) and the rest of the market is the smallest it has been in more than 20 years. Of course, the market overall is very pricey; finding undervalued stocks in this environment has become increasingly difficult.
To adapt, you need to understand that there are two types of value stocks. The first are statistically cheap — their cheapness stares you in the face. This breed is quickly becoming scarce; even Hewlett-Packard Co. and Xerox Corp. are now found in growth investors’ portfolios. But before I talk about the second type of value stocks, let me tell you how my wife and I bought our house.
It was 2005. The housing market in Denver, just as in the rest of the U.S., was getting bubbly. Our family was about to grow, though we did not know it yet. We had sold our condo and were renting month to month and thus were under no pressure to buy a house, but we were keeping our eyes peeled for the right one at the right price. It was a nine-month journey. We even made some offers (usually below the asking price), which the sellers laughed at. They were right; their houses sold above the asking prices in just a few days.
I vividly remember how we finally found our house — and I have to admit it was entirely my wife’s doing. We were flipping through photos of house listings that met our criteria. We stumbled on a picture of an ugly green house with a bright red garage door, which had been on the market for six months. I made a snarky comment that this house would be on the market for another six months and was about to click to the next, but my supersmart wife said, “Wait.” She skipped all the pictures of the ugly outside and zeroed in on the photos of the interior of the house.
To my great surprise, this ugly duckling was ugly only on the exterior and had been completely redesigned inside. It was a perfect house for us. Since it had been on the market for a long time, the seller was willing to accept our low offer. I, like everyone else who did not buy this house for six months, was turned off by an ugly outside (which could be easily corrected with some paint) and failed to look deeper.
Back to the stock market. The other breed of value stocks are the ones with “ugly green paint jobs and bright red garage doors,” the ones that look unappealing from the outside and aren’t even cheap, at least not according to the statistics at everyone’s fingertips. Often, backward-looking statistics don’t capture such companies’ true earnings power, as it has yet to show itself. These are the stocks you should patiently seek out, especially in today’s value-deprived environment.
A stock that comes to mind is Micron Technology, a maker of memory chips. Micron has destroyed more capital over the years than Communism and Socialism combined. To be fair, it was not Micron’s fault: Its profitability — or lack thereof — was determined by its industry. Micron was a large player in a very fragmented business that Asian governments thought was strategic to the development of their countries, and so they subsidized their local companies. The memory industry was ridden with overcapacity. But nothing transforms an industry better than a financial crisis. The 2008–’09 global recession weeded out the weak players, and Micron bought the last one, Elpida Memory, in 2013 on the cheap, almost doubling its revenues.
Now the DRAM industry has only three players: Micron, Samsung and SK Hynix (a South Korean version of Micron). NAND memory (used in flash and solid-state drives) has the same competitors plus SanDisk Corp. Barriers to entry are enormous — a new entrant would have to spend billions of dollars on R&D and then tens of billions on factories. Therefore this cozy, oligopolylike industry structure is unlikely to change. Samsung, the largest player in the space, has an extra incentive to keep chip prices high because they give it a competitive advantage against Apple and, more important, against low-end Chinese smartphone makers that have to buy memory at market prices.
Gross margins of all memory companies have been gradually rising and still have significant room to grow. If Micron achieves its target margin level, in the mid to high 40s, its earnings will hit $4 to $6 per share in a few years, giving it a modest price-earnings ratio of 4 to 5 times. This is one cheap “ugly green paint job, bright red garage door” stock.
This article was originally published in Institutional Investor Magazine