These four fund managers' secret to success: Don't go with your gut on stocks
By Philip van Doorn, MarketWatch
What investors need is 'second-level thinking' to avoid making mistakes
Are you the type of investor who goes with your gut or follows the herd? Or do you deliberate, considering a company from all angles -- even trying to find the flaws in your own thinking?
Taking the extra time can help you improve the performance of your investments.
This recent article by Charlie Bilello (https://pensionpartners.com/fast-food-slow-thinking/) provides plenty of food for thought, using two-year stock charts for McDonald's Corp. (MCD) and Chipotle Mexican Grill Inc. (CMG) as examples.
The two stocks have taken divergent paths in that span:
Hardly anybody predicted that Chipotle would suffer so badly -- and for so long -- from the food-safety problems that began in July 2015.
Remember that, before Chipotle's decline, many investors just "knew" that its restaurants represented the wave of the future for fast food and that stodgy McDonald's could never compete in food quality or service.
Chipotle, famous for its made-to-order burritos since it went public in 2006, was growing quickly and faring better in customer-satisfaction surveys. McDonald's, meanwhile, had a new CEO who was trying to turn around the hamburger chain. An investors's first reaction might be to buy shares of Chipotle and avoid or short-sell McDonald's. Bilello calls that "first-level thinking."
Bilello goes on to describe "second-level thinking." An investor might have concluded, upon deeper reflection, that Chipotle's stock was overvalued, or that its earnings might not rise as quickly as expected. The burrito chain might even suffer from growing pains, which is common in the industry. The investor also may have been attracted to the low valuation for McDonald's shares, and expect its earnings to decline less than expected. McDonald's, after all, has weathered many storms since its founding in 1955.
In the end, the investor who picked old-school McDonald's over new and exciting Chipotle made a lot of money.
We spoke with four professional money managers, and each named at least one company they thought was undervalued based on their own second-level thinking:
Richard "Trip" Miller of Gullane Capital LLC said he is always looking for a "catalyst" for bargains among companies or industries that are out of favor with most investors.
"With everybody being so negative so long on retail, a lot of really great businesses have unfairly gotten punished," he said, singling out Dollar General Corp. (DG)
What sets Dollar General apart from most U.S. retailers is its rapid expansion. The company plans to open 1,000 new stores this year, while purchasing another 300. It had 13,429 stores as of March 3, and Miller expects it to expand to 20,000 within five years.
One reason for the company's ability to survive, and even thrive, during the "age of Amazon," according to Miller, is that 70% of its stores are in markets with fewer than 20,000 people. In those areas, people "are more likely to walk or ride a short distance for daily purchases," he said.
Miller complemented Dollar General's management team for using "zero-based budgeting," which means that every year they scrutinize every type of spending, rather than assuming a certain percentage increase for budget items. He appreciates the company's continued share repurchases.
Shares of Dollar General closed at $75.38 on Sept. 8, down 1.4% this year. Still, since 2010, the shares have risen over 30% in three calendar years.
There have been some pretty wide swings over the past year:
"We would buy more below $70," Miller said.
Marc Halperin is a co-portfolio manager of the Federated International Leaders Fund . He believes shares of Allied Irish Banks PLC are undervalued, trading at roughly book value. With so many investors getting burned when Ireland's banking sector imploded in 2008, it's no surprise that many are still shying away.
He expects the shares to rise to 1.4 or 1.5 times book value. "We are looking for at least 40% upside on [the stock], and that is conservative," Halperin said.
Allied Irish Banks is the largest bank in Ireland, with nearly 300 branches, and Halperin said it has "a better distribution system" than its peer, Bank of Ireland, because Allied Irish has about 1,100 through An Post, the country's official provider of postal services.
Before the financial crisis of 2008, when Ireland's economy was rapidly expanding, Halperin said he and his colleagues were not comfortable with Irish banks because of their aggressive expansion. In 2008, Allied Irish Banks' ratio of loans to deposits was roughly 220%.
But nine years later, "most people really are not aware of the restructuring going on at the bank," he said. The loans-to-deposits ratio now is about 100%, he said. He also said the bank had whittled down its nonperforming loans to 6.7 billion euros from 29 billion euros at the end of 2013.
Halperin said the improved health for Ireland's economy, which grew 5.2% in 2016, according to the Organization for Economic Co-operation and Development (http://www.oecd.org/eco/outlook/economic-forecast-summary-ireland-oecd-economic-outlook-june-2017.pdf), bodes well for the bank.
"We are looking for about 5% GDP growth this year," Halperin said. U.S. gross domestic product growth, in comparison, was 1.6% in 2016.
John Buckingham is the editor of the Prudent Speculator newsletter, which recently had a No. 1 ranking for performance since its inception 40 years ago from the Hulbert Financial Digest. Buckingham and his team manage money following the Prudent Speculator strategy through AFAM Capital.
"The gist of second-level thinking is the whole crux of value investing," Buckingham said. "We are trying to buy things that are on sale, because investors have lost interest in the company because of events that are more short term in nature, or because fears of the future that may be overblown."
He said "value stories are usually hard to sell people on," while growth stories are easy to sell.
Buckingham likes General Motors Co. (GM), which trades for only 6.3 times the consensus 2018 earnings estimate, among analysts polled by FactSet. Tesla Inc. (TSLA) has a market capitalization that is higher than GM's, even though the relatively small electric-car maker is projected to lose money this year and next. So one can't compare price-to-earnings ratios for the two companies.
But if one wishes to make a bet on the increasing popularity of electric cars, Buckingham believes GM, with its 13% market share in China, is a safer investment.
"I would rather do it with a company that is making money and is not going to have to tap the capital markets to keep operating," he said.
The Chevrolet Bolt electric car was named Motor Trend's car of the year for 2017 (http://www.motortrend.com/news/chevrolet-bolt-ev-2017-car-of-the-year/).
Buckingham noted that General Motors is dissimilar to the "old GM" that went bankrupt in 2009 after being saddled with "massive debt and pension obligations."
Investors' concerns about a possible peaking of U.S. auto sales are valid, Buckingham said. Still, GM's bar has been set low, and if it traded at its five- and 10-year average price-to-earnings ratio of 8, that would imply 27% upside for the stock, he said. Patient investors can also savor GM's dividend yield of 4.12%.
Buckingham sees similar overreactions over Kroger Co. (KR) shares in light of Amazon.com Inc.'s lowering of food prices after completing its acquisition of Whole Foods. He also likes Target Corp. (TGT) and Wal-Mart Stores Inc. (WMT) as retailers that are undervalued because they are "being penalized by the news" surrounding Amazon's dominance.
Larry Pitkowsky, co-manager of the GoodHaven Fund said he tries to avoid following the herd.
"We are always looking for situations where we differ from the market," he said. "That is where you find inefficiencies and potential bargains."
He reiterated his positive take on Barrick Gold Corp. (ABX.T), the largest gold-mining company in the world. Pitkowsky was featured in a MarketWatch interview in July 2016 (http://www.marketwatch.com/story/two-veteran-stock-pickers-win-by-going-where-others-see-fear-or-disinterest-2016-07-26).
Barrick is still the largest position of the GoodHaven Fund. Gold prices on Friday rose to their highest level in a year, helped by a falling dollar and weaker equities amid a "risk-off" sentiment by investors.
Pitkowsky made the case on Barrick again.
"You still have the opportunity to invest in a sector that is not popular, with a new management team, where they have proven themselves to be very strong operators, and where you have reduced leverage and costs," he said.