Value investor likes to buy cheap and sell dear. But sometimes the apparent cheapness could be very costly.
Research in Motion(股票代號: RIMM)(substitute your own here such as First Solar(股票代號: FSLR), Groupon(股票代號: GRPN), and many more), a wall street darling that was once dubbed one of the four hoursemen along with Google, Apple, and Amazon. Prior to 2008, this company seemed can do no wrong. Corporations preferred RIMM’s Blackberry mobile device over most other handsets because of corporate emails. This seemed to be a differentiating competitive advantage that was absolute and difficult to dispute against with then, but how fast such competitive advantage eroded. Hindsight is always 20/20. Fast forward 4 years later, the company is trading at 1/14th the level from its high of $140+ back in 2008, it’s current P/E ratio is a despicable 4.62 depicting the investor pessimism surrounding this company(For comparison, my estimation of the fair P/E of a stable but zero growth(WTF?) company should be around 9, but we will delve into this at another time). The company’s book value is $19.59, and it has $0 debt on its balance sheet. At $10 dollars plus change, RIMM is trading at a substantial discount to its book value. You may ask, is RIMM cheap?
The framework to valuating companies and their securities depends on what you are going to do with the companies. Unless you are a Private Equity(Corporate raider) firm, you probably won’t even consider prying open the company, do an appraisal of all assets and their market values at liquidation prices, hopefully you will find some hidden values when comparing it to the cost of your acquisition and financing, deal with the grumble minority shareholders, management, and board of directors, search for possible bidders of such assets, and ship them off piece by piece, otherwise, I would suggest you proceed to the next paragraph.
According to Graham, Dodd and John Burr Williams, the price of a company should be based on its balance sheet, the income statement, and the expected future cashflow. Expected future cashflow is one of the reasons why the stock price of a company can be significantly different from its net asset value(book value for our purpose). Think about the cost of setting up a hot dog stand on the street corner, it is not the equipment costs that determine the wealth of the owner, but the number of hot dogs the stand can sell that determines the owner’s financial well being. There can be numerous reasons why the hot dog stand does well or poorly: it could be the secret sauce on the dog that captivates the customers, it could be the real estate it is occupying, a monopoly within several blocks of high foot traffic from hungry patrons, it could be the hot dog stand owner is a great salesman, these winning factors are the stand’s competitive advantage. On the other hand if the stand owner is not making enough sales to pay for the costs of running the business, or if the profit is so tiny and its prospect might not get any better, you can be certain that the intrinsic value of this hot dog stand as an on-going business might be much lower than simply selling off the equipment. Some businesses require lots of assets, while some require less, these are industry specific characteristics and we will discuss more at another time. The fact that the economic future of RIMM is clouded, with its sales declining rapidly, pretty much indicates the expected cashflow in the future is less than certain. Personally, the nail in the coffin came to light when a friend of mine who works at his corporate’s IT department showed off his iPhone a few years ago when his company began adopting the iPhone and ditching the Blackberry.
Unless your investment thesis involves betting(with a high level of conviction, of course) that some white knights coming in to save RIMM(or you) and pay a higher price than what you paid for, or some magical corporate restructuring or turn around is in the making, or the company will somehow redeem itself and its old glory through a revolutionary product, which is at the mercy of consumers’ fickle taste, I would suggest you continue on your search for something better and brighter. In such a case, an option strategy such as the long straddle or strangle may be a good way to play the increasing volatility of the underlying.