The Ones That Got Away

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Stock investors sometimes regret "the one that got away," a stock that they looked at, decided not to buy, and then that had a great run. I'm here with Matt Coffina--he is the editor of Morningstar StockInvestor newsletter--to talk about some of his missed opportunities and what he has learned from them.

Matt, thanks for joining me.

Matt Coffina: Thanks for having me, Jeremy.

Glaser: Let's start with the big picture. Is it a good idea for investors to really look back at stocks they didn't purchase and do a postmortem on it? Or should they really just be focused on looking at future opportunities?

Coffina: That's a good question. I think the answer isn't totally obvious. My view is that, yes, it is worthwhile to look back at both the stocks that you bought and the stocks that you passed on to see what kinds of lessons you can learn for the future. But with the big caveat that there are always going to be far more missed opportunities than there are opportunities that you actually took advantages of, especially in a concentrated portfolio.

Our Tortoise and Hare portfolios have less than 20 holdings each. And Morningstar covers some 1,500 companies globally, and there are many more thousands that we don't cover. There are always going to be many more stocks that you missed out on. So, I don't think you should get too bog down on the would-haves, the could-haves, and the should-haves.

If anything, that might make you a little not risk-averse enough when you see in retrospect these companies that did wonderfully; it could be tempting for some investors to chase those opportunities or similar opportunities in the future. It's not always obvious in retrospect what the risks were a couple of years back when you were considering, without the benefit of hindsight, some of these opportunities.

But that said, if you can maintain discipline and maintain focus, I think that it is a good idea to look back and see what went wrong or what you might have missed and what lessons that might hold for the future.

Glaser: What's an opportunity that you passed on and maybe a lesson that you've learned from that?

Coffina: Two, in particular, stand out from the last couple of years. There were two stocks that I was looking at toward the middle of 2013. Apple (AAPL) was one in April 2013; the stock was down about 40% from the previous high. It popped up on my radar; it was trading at a pretty steep discount to Morningstar's fair value estimate.

The other one is Gilead Sciences (GILD), which I was looking at around June-July of last year. In that case, the stock was actually up about 100% from the prior year but still looked pretty reasonably valued relative to Morningstar's fair value estimate. The stock was trading in the low-50s, and I think our fair value was somewhere around 70 at that time. And both of those stocks went on to perform extremely well, vastly outperforming the S&P 500.

So, maybe we'll start with Apple. What went wrong in that case, I think, is that I was overly focused on the long-term risks. Certainly, the history of the consumer electronics industry is not promising. There are plenty of companies like Nokia (NOK) or BlackBerry (BBRY) in the past that have done extremely well and then promptly within a couple of years just fell apart. Apple was basically priced as if that was going to happen to them. The stock, early last year, was trading at about 6.5 times earnings, if you excluded cash on the balance sheet. So, it was basically priced as if the business was going to collapse within the next few quarters, and obviously that didn't happen.

But even at the time, we could have known that that was very unlikely to happen. Apple still enjoyed a lot of brand loyalty. They enjoyed increasing switching costs related to the iOS ecosystem various applications, media content, and so on that people owned within the iOS ecosystem that was tying them more and more into it. So, it was unlikely that earnings were going to collapse. In the subsequent year and a half, earnings were under pressure for a time. They sort of stabilized here. Revenue growth was certainly much slower than it had been in the years prior; but at 6.5 times earnings, Apple wasn't pricing in much in terms of expectations, and I think the valuation more than offset the potential longer-term risks.

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Glaser: And what about Gilead? How has it changed the way that you think about looking at those kinds of firms?

Coffina: So, it's a similar story with Gilead, where I was probably overly focused on long-term risks. Gilead has this hugely successful hepatitis C drug, Sovaldi. It is on track to be one of the best-selling drugs of all time just in its first year of launch. However, I was concerned about the sustainability of those earnings, again.

Hepatitis C patients take this drug for about three months, and then the vast majority is cured for life, which means that Gilead has to constantly replace patients with new patients. And then the number of new diagnoses of hepatitis C is actually fairly low--as nowadays, we have effective screening of the blood supply. So, people are much less likely to contract hepatitis C.

There's a very large population of people with chronic hepatitis C infections, and there was this big pent-up demand for a breakthrough therapy. But I'm worried about what happens three, four, or five years from now when, at the very least, it will be very difficult to sustain growth for this drug. We actually expect sales of Gilead's hepatitis C drugs to peak within their first couple of years on the market--which is very different from the sales profile we see for a lot of drugs, where sales steadily ramp up over time and they often don't reach their peak sales until the last year when you lose patent protection and generic competitors flood in. So, peak sales often come at the end for drugs. For Gilead's hepatitis C drugs, it looks like they are probably going to come more at the beginning, and then that will slowly trail off over time as they get through this pent-up demand.

But that said, similar to Apple, Gilead was trading in retrospect at a very, very cheap valuation toward the middle of last year. The earnings for 2014 are expected to roughly quadruple from prior-year levels. So, they are expected to earn about $8 a share this year versus earning about $2 in 2013. Knowing that now, we know that Gilead, toward the middle of last year, was trading at also about 6.5 times forward earnings--so, a comparable valuation to Apple.

I think the lesson in both of these cases that does have some application for the future is that, while we definitely do want to stay focused on the long term (and one of our key advantages, I think, over other investors is our long-term focus, our willingness to look past the headlines and the short term), that long-term focus shouldn't be an excuse for missing out on potentially very significant short-term opportunities.

So, if you have a case where either the stock is priced for disaster and that disaster is not really likely to occur--which was the case with Apple--or you have a company that's on the verge of a huge breakthrough or a huge jump-up in earnings and that's not really being priced into the stock either, in those cases the short-term opportunity could outweigh the longer-term risks and maybe we don't need to focus as much on the long term, if there is this huge short-term opportunity.

Glaser: Finally, are there any companies that you looked at over the past few years that you're glad you didn't buy, where you see that you really made the right choice there?

Coffina: There are plenty of those as well. Even in the strong bull market where you could have owned almost anything and done very well--which, again, sort of clouds your view when you're looking back at missed opportunities (in a strong bull market, a lot of things are going to seem like missed opportunities in retrospect)--but even in this environment, there are stocks that we passed on or that we sold that ended up being good ideas.

One category would certainly be companies with deteriorating competitive positions, or what we call negative moat trends. I would say a great example there would be Weight Watchers (WTW), a company that we thought was undervalued for a time. But really, the competitive position was being steadily eroded by competing weight-loss solutions, especially technology-enabled ones--weight-loss apps and fitness trackers and that sort of thing. So, that's a company that I'm glad we avoided.

Another one would be situations where companies are very influenced by commodity prices, especially if that's tied into a negative moat trend. So, a company like Cloud Peak Energy (CLD) comes to mind, where they're facing all sorts of secular headwinds to coal demand anyway; but they are also very sensitive to natural gas prices and coal prices. That's a stock that we actually owned earlier this year, and we had an opportunity to sell it at pretty close to fair value, thanks to a runup in natural gas prices after the cold winter. And natural gas prices have subsequently weakened a lot. It's not something that I could have predicted, but I could have predicted that it would be very hard to predict future natural gas and coal prices. So, without that very steep discount to fair value and with the secular headwinds in mind, I am certainly glad in retrospect that we sold Cloud Peak.

Glaser: Matt, thanks for the look back on some of the names you chose not to buy.

Coffina: Thanks for having me, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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