Four Stocks Mispriced by the Market

When you buy a stock, you're making a bet that you are right and the market is wrong. Perhaps you think that you know something that's not reflected in the market price, or perhaps you simply have a different point of view about the company's prospects. Either way, you're staking out a different position than the average market participant.

You've likely thought quite a bit about why you like the stock, and hopefully, you've thought about why it's a good value. But how much thought have you given to the reasons why your opinion differs from the consensus? Not much, probably--but exploring what hedge-fund manager Michael Steinhardt has called your "variant perception" about a stock is a great way to test whether your investment thesis is sound, or whether it needs shoring up.

For example, when I bought  Weight Watchers (WTW) last year, I was attracted to the firm's great economics and strong competitive position in what I felt would be a steadily growing market (no pun intended). That was the investment thesis, but those attributes of the firm were readily apparent to anyone who looked at it for more than five minutes.

My variant perception was that the Atkins craze was just that--a fad--and that the slowdown in attendance at the firm's meetings would rebound when Atkins became less popular. The market, on the other hand, seemed to be pricing the stock as if Atkins were here to stay. Knowing why my opinion differed from the consensus gave me greater confidence in my investment thesis--as popular as Atkins was, I've yet to see a diet that stays hot forever.

I've made a list of what I think are four of the more common reasons why stocks become temporarily cheap, and become attractive investment opportunities. If you're digging into an investment, and your variant perception about the company falls into one of the following categories, odds are good you've found something interesting.

Time Keeps on Tickin'
Wall Street's short-term focus is something that every savvy investor takes advantage of at some point, but even I have to chuckle when I see Wall Street publicly admit that a firm's troubles are only temporary--but take the stock to the woodshed anyway. This happened last summer with  American Power Conversion , a high-quality company that makes (essentially) big batteries for power-hungry tech gear. The firm announced that it was going to invest more heavily than Wall Street expected in marketing and R&D for a new product it was about to launch, which would mean depressed earnings for a few quarters. I remember reading sell-side reports that basically said, "While we're still excited about the potential of InfraStruXure [the new product], we're lowering our rating on the stock." We increased our fair value estimate, APCC earned a 5-star Morningstar Rating for stocks at about $16, and the stock's done quite nicely since.

I think this exact same scenario is playing out with  International Game Technology , which currently has a 5-star rating. Growth at this dominant slot-machine manufacturer has slowed for a variety of reasons, all of which we think are temporary. Nothing has changed with regard to the firm's market leadership, high returns on capital, and long-term potential--the number of jurisdictions that allow gambling continues to grow--and so the stock looks pretty cheap if you're willing to look out past the next couple of quarters. The funny thing is, I've read comments from Wall Street that agree the long-term story is great, but base recommendations on what will happen next year. Here's an example from Jeffries & Company:

"We are maintaining our Hold rating…. We believe the company has great long-term fundamentals and we like the story into FY 2007, but for now our valuation is based on FY 2006, and to account for our newly lowered EBITDA estimate we are lowering our price target to $29.50, down from $32."

That's how some Wall Street folks view the stock. For an article that gives an overview of our variant perception of IGT, click here.

It's Merely a Scratch
A related--and reliable--reason why the market misprices stocks is when the consensus mistakes a fixable problem for a terminal flaw. This was the case a couple of years ago at both  McDonalds (MCD) and  Home Depot (HD)--Mickey D's was focused on opening less-profitable new stores instead of wringing cash out of its existing store base, and Home Depot's customer service was suffering after new CEO Bob Nardelli replaced many full-time employees with less-knowledgeable part-timers. Neither of these issues were fatal, however--McDonalds cut back sharply on new store openings and returned cash to shareholders, Home Depot lessened its dependence on part-time employees, and both companies recovered nicely. Both these companies had problems that were fixable, since their main competitive strengths remained intact.

(A colleague of mine calls this the "Wall Street ruler effect"--Wall Street puts a ruler under the results from the past two quarters, and projects those results out for the next few years.)

A current opportunity in this category is  3M (MMM). Wall Street crushed the stock a few months ago when Jim McNerney announced that he was leaving to take the helm of Boeing, but being leaderless is not a permanent problem. And even though McNerney made some important changes at 3M, such as more targeted R&D spending, it's tough to believe that these won't persist after his departure. The market thinks 3M is worth 20% less now that McNerney's gone, which seems excessive.

Playing to an Empty House
Here's a more subtle reason why the variant perception on a stock is more likely to be right than wrong: The company is changing, but investors are slow to realize it. You see this a lot with companies that are maturing, shifting from fast top-line growth to cash generation.  Microsoft (MSFT) is the prime example of this type of mispricing. It's no longer growing at the 20%-plus rates of the past--and it's unlikely that it ever will--so the tech- and growth-focused investors who used to love the stock don't want anything to do with it.

Meanwhile, the value crowd is just starting to realize that mature tech companies can generate just as much cash and be just as reliable as the stalwarts they're used to buying in other industries. Considering how much cash Microsoft generates, its almost-unassailable economic moat, and the fact that it's managed by one of the few shareholder-friendly management teams in technology, I think it's just a matter of time before it climbs out of Wall Street's doghouse.

The Only Child
A fourth reliable source of mispricing: Stocks that Wall Street doesn't understand for one reason or another. I've written about spin-offs in the past, but one-off companies are in a similar boat. When a company has few--or no--publicly traded direct competitors, it tends to be less-covered by Wall Street, and interest from big money managers is often lower. In my opinion, this is what happened to  Moody's (MCO) when it was spun out of  Dun & Bradstreet  some years ago, and it's one of the reasons why  Compass Minerals (CMP) is cheap enough to merit a 5-star rating. 

Compass--which owns the largest salt mine in the world and is North America's dominant producer of road de-icing salt--is an odd bird. Other large salt-producing entities are buried within chemical firms ( Rohm and Haas ) or private firms (Cargill), and so the firm flies largely beneath Wall Street's radar.

In fact, I'd argue that this is one of the reasons why  Berkshire Hathaway (BRK.B) is as cheap as it is right now. Berkshire is truly unique, but people still think of it as a closed-end fund that derives its value largely from holding big stakes in companies like  Coke (KO) and  Gillette . However, the company is actually a complex capital-allocation machine that generates cash from its (very large) insurance business--and other mature businesses--and redeploys the money in areas that need capital to grow, like Mid-American Energy and NetJets. Berkshire's value derives largely from its unique characteristics, but unless you take the time to understand it, that value's not apparent. 

Know Why You're Different
The next time you think about buying a stock, give this topic some thought. Why is the stock mispriced? How does your opinion differ from Wall Street's? Does your research benefit from an investment moat? If you like the answer to these questions, odds are even stronger that you've found an attractive investment idea.