The Trouble with Cheap Stocks

They're cheap for a reason

You get what you pay for.

It’s why I avoid things that are cheap. Cheap haircuts, cheap tax advice, and cheap tennis balls don’t do anything to motivate me.

Double that when it comes to food. The last thing I want is a cheap meal. It’s not the tablecloth and ambiance I want to pay for…it’s the ingredients. Garbage in, garbage out. No thank you.

People love a bargain. It’s seductive. The idea of getting your hands on a valuable item for less than the prevailing price does something to our lizard brain. It taps into our primal wiring.  

We all know what better feels like. Filet and hoof both come from the beef cow. One is demonstrably more enjoyable. The temptation to load up on discounted filet is more than we can handle. It’s only later we realize the haul is either stolen or rancid. Either way, beware of discounts.

It means that outside of rare occasions, cheap things are cheap for a reason. It’s especially true with stocks.

“Could Turn Around…” Probably Won’t

Last week I went to visit one of our portfolio companies. I liked what I saw.

I got a firm handshake from the CEO. He also said one thing in conversation that stuck with me. More on that later, past the paywall. Remember, you get what you pay for.

CEO of our portfolio company

This company is not cheap from any angle. It trades at a slight premium to its peers on all metrics. I visited its stores, bought products, talked to the staff. But the real test was meeting management, testing their handshake, and comparing that to the numbers.

A side benefit to meeting with companies is you get to know other people doing the same thing. There were more than a dozen other investors on my trip.

Most people taking the time to visit a company are analysts. You’ve seen research reports, heard people cite analyst opinions, and likely value both. That’s a mistake.

I’m here to tell you first hand, most of the analysts covering stocks are excessively focused on details…to a fault. They’ll study the rivet on the handrail of the Titanic and miss the fact they’re on a ship.

I felt that way when I went on this trip, what I heard and observed during the day confirmed it. I was the only person on the trip who’d been into the company’s store, bought products, and used the products. Sitting in a cube studying numbers is only a small part of stock analysis.

And it leads to statements like this. “I think it has a lot of upside if it turns around.”

It’s what an analyst from Cleveland told me about a competitor to our pick. Sure, it’s cheaper on every metric.

Our company has ~6,300 stores. The market values the stores at ~$10.2 million.

The “cheap” company the analyst likes has ~5,100 stores…which is almost the same amount. The market values them at a stunning ~$575,000 per store.

That means when we buy our stock, we pay ~18-times as much per location. On the surface, it’s looks like a rip off. If you visit stores, it looks like a bargain.

What Cheap Looks Like

My new analyst friend was smart…much smarter than me.

What I mean by this is he was a math whiz. He had Microsoft Excel skills that tower over mine. I can make two spreadsheets talk to each other. I can make first or second order assumptions based on changing variables. After a certain point, I lose interest.

This guy can tell you what happens if the company’s power bill rises by 1%. He’s on top of it… and I respect it. But I’m not sure it helps when it comes to stock picking. In fact, I think it hurts.

Excessive focus on details turns into a haze. All you see is the tree. The fact that you’re in a forest gets lost.

He told me our company’s competitor was dirt cheap. I told him I’d visited the stores…and it felt like a swap meet.

Competitor’s store entrance

Again, he’s smart. He acknowledged issues. He told me the prior CEO came from outside the industry. Pepsi to be specific. He had no expertise. After a brief tenure, he left, collecting a hefty payout in the process.

I’ve sat on public company boards. The decision process when hiring executives would mortify you. The board is terrified of being sued. They hire a headhunter to produce candidates.

The headhunter is also terrified of being sued. It produces a diverse slate of candidates from across mildly related industries. The board has an independent search committee tasked with selecting the new leader.

You’d think direct industry experience mattered. In the case of our portfolio company, the CEO started working at the store counter when he was 18. While some argue that makes him myopic, at least he knows the business from the ground up.

After the ultra-independent board chooses the superbly independent leader, they craft a royal pay package, including proper compensation for parting ways, which is inevitable.

In the case of this competitor, the former snack food executive and other corporate champions produced this result for shareholders.

Cheap gets cheaper

Meanwhile, our arguably less sophisticated counter worker turned executive focuses on the business he knows. He visits stores. He asked me about my visit to stores. He listened intently, thanked me, and discussed my experience.

This is his stock, our stock, over the same four year period as the prior chart of the “cheaper” competitor.

You get what you pay for…

Let’s be clear on the details. Our stock looked expensive the entire time. It ran 142% over this period. Sure, some stocks did better. NVIDIA did better… but it’s hard to own one stock. And it’s subjective to ignore the entire market.

The 142% gain looks like an escalator. Up led to up for years on end. It even seems boring at times. With the price always high, investors had to hold their nose and buy. The results were good.

Meanwhile, the competitor hired executives from unrelated industries. Analysts argued there was turnaround potential. The stock fell 69% over the exact same period.

Cheap got cheaper. The better operator was expensive for a reason. We’ll stick with it.

The Only Exception

The older I get the more I resist simple answers to complex questions.

Most of the time, our need for reliable, simple statements to explain life leads to trouble.

The right answer for most questions is, “It’s complicated.” That’s because, there are exceptions to everything. Stocks do occasionally get cheap. When they do, it’s wise to buy them.

But they don’t get cheap one compared to the other. If a competitor sinks while others thrive, there’s often a deeper problem. Cheap looks different when it’s a good idea.

For example, In January 2016 I had a memorable dinner I describe as unbelievably cheap. This coming from a man who detests cheap meals.

The setting was Restaurante Mee in the Copacabana Palace, a Belmond hotel in Rio de Janeiro. Michelin awarded the exquisite Japanese menu one of its coveted stars shortly prior.

I had a friend with me. He had local contacts that made the trip run smoothly. I suggested we experience the restaurant before leaving for the next leg of the trip. We had four waiters, and ate until we couldn’t see straight. The cost…$80 per-person.

Restaurante Mee didn’t go cheap on the fish, or beef, or anything for that matter. There were more staff than patrons when we visited. The issue was the currency.

The Brazilian real absolutely tumbled in the weeks leading up to our visit. It made everything cheap. Food, hotels, taxis, even stocks sold at bargain prices. It didn’t last…and if we visited the same restaurant today, I bet we’d pay many times that amount for the same meal.

It means we sometimes get rare opportunities to buy bargains. When we do, it’s scary. Buy when others panic is a fun thing to say, but harder to do.

And the key job for us as investors is to know the difference between a real bargain, and the more common desire to get something of value cheaper than the next guy…which almost never works out.

We’re Adding an Unlikely Stock Today

I’m surprised at how few comments we had on the last issue. I read all your comments.

Several people reached out to ask me if Kyle is a real person. Yes, he’s very real.

Also, I mentioned the two investors who bought the 11 factories bankrupted by Kyle. Those investors are also real.

This is a relatively large newsletter. People know people. One of you recognized the investors, and forwarded him the issue about Kyle. Here’s his response. I’ll obscure his email for obvious reasons. Talk about fact checking…

Fact checking on the next level…

I’m surprised how often people ask me if I use AI to write this newsletter…never. As you’ll see in my new book next month, I write because I have something to say. You read because you have something to learn. It’s a symbiotic relationship.

Today we’ll add a new stock to the portfolio. It’s an unlikely addition, and it’s not cheap. In time we’ll see if it’s expensive for a good reason.