Fallen angels: finding undervalued stocks
Jonathan Boyar, director of Boyar Value Group and advisor to the MAPFRE AM US Forgotten Value Fund
The same herd behavior that can push a company’s share price to gravity-defying heights can also send share prices plummeting when a formerly high-flying company stubs its toe. In such cases, investors often leave the stock for dead or simply don’t want to wait to see whether management can turn things around. And as skittish investors move to the sidelines, share prices fall even farther.
Opportunities can be hiding amid the wreckage of these companies, but investors must be careful. Yet those who can spot the opportunities and then be patient enough to let things play out (and who can stomach paper losses) can find great bargains among the “fallen angels” of Wall Street.
What are fallen angels?
At some point in their trading lives, these stocks captured the imagination of institutional investors—perhaps because they were run by a particularly talented empire builder, owned a particular technology, or pioneered a new industry or business model. At one point, nothing could go wrong; everything connected to them seemed blessed—and then the euphoria set in. Few feelings can compete with the power of a bull stampede when everyone is making money hand over fist.
However, the bigger and longer the party, the more painful the hangover. Some stocks never recover because the original bubble had no real basis. Others don’t recover because the speculation depended on the success of a particular technology.
The most common example of a fallen angel is a stock whose unrealistic trading multiple doesn’t incorporate the company’s real long-term prospects. Wall Street is so focused on the positive short-term events occurring in the business that any predictable slowdown or change in the environment is dismissed. But investors must remember that top managers are human, too: When business is going well, optimism seems natural. Constantly warning investors about the reasons the environment is so good can be difficult, particularly when a high stock price comes with significant advantages, such as stock options, acquisitions, and raising equity.
When a company’s stock price takes a dive, the loss of credibility can be disproportionate—almost as if the company is radioactive. Its stock is shunned for months or even years because of the size of the decline. Such a company can be built up again by revising expectations and consistently beating them, but the process takes time. Most fallen angels never revisit their former outrageous multiples, because those multiples weren’t grounded in economic reality in the first place. The crowd moves on to the next company operating (for the moment) in the perfect environment and boasting growth as far as the eye can see.
But as patient investors ourselves, we have found that fallen angels are a great place to look for investment ideas. Their stocks may be dead money for a time, but the initial entry point is low enough that compounded annual returns should be attractive.
What’s more, fallen angels are another area where individual investors have an advantage over professionals. As we’ve already noted, a former high-flyer may take years to regain altitude. As a result, these stocks can drag down the short-term performance numbers that professional investors are judged on. Individual investors, however, don’t have to worry about losing clients, so they can afford to take the long view—as long as they tread carefully. Since fallen angels can reach ridiculously low valuations, it may be prudent to buy into them slowly (e.g., through dollar-cost averaging) rather than jump in all at once—leaving yourself a little dry powder that you can use to take advantage of even lower prices.
How can you find fallen angels?
Do we have a proprietary algorithm that spits out fallen angels or that can predict the precise timing for a turnaround? Unfortunately, we don’t. To find appropriate investments, we rely on decades of experience as we sift through a barrel full of possibilities. But here are some rules of thumb that we apply to the process:
Perhaps the industry was previously ascribed a high multiple or had historically high margins or the potential to reward shareholders with high returns on investment and decent long-term growth prospects, but now some negative near-term event has created an investment opportunity.
We frequently say that we would love to own XYZ stock—it’s a great company, but it’s just too expensive right now. Then, for whatever reason, XYZ declines. The stock might not be cheap by our usual standards, but we’re unlikely to see it this cheap (relatively speaking) again.
Or maybe we’ve made money with this stock in the past. Fond memories can often prompt us to take another look at an old friend. Keeping previously owned companies on a watchlist is an excellent way to spot fallen angels. After all, when the situation presents itself, you’ve already built a tremendous knowledge base about the company that you can leverage to help you determine whether the selloff is an opportunity or a permanent overhang.
Then there are fallen angels created by disaster events. Often we have to estimate whether the problem will be temporary or whether it will be a permanent issue that will continue to weigh on the company’s share price. Chipotle’s issues with food quality and health provide a perfect example of a company that became a fallen angel following a health crisis, only for the resulting share price decline to become an opportunity as the Company overcame its challenges.
Avoid value traps: look for catalysts
When an entire industry or sector falls out of favor, investors have to keep a sharp eye out for value traps. The key is ensuring that the sector has an opportunity to recover—that the industry or product category isn’t on its way to becoming obsolete. Once you’ve done that, you can look for the strongest companies in the sector, then add equity exposure and wait for a turnaround.
When you’re dealing with individual companies instead of whole industries, there’s less room for error if the expected recovery is delayed or never takes place. To succeed, you need a firm conviction that you’re not about to fall into a potential value trap. Telling the difference between a value trap and a fallen angel means identifying a catalyst that could drive the stock back up. If you can’t point to something specific, it’s more likely that you’re looking at a value trap than at a solid investment opportunity.
"It never was my thinking that made the big money for me. It always was my sitting".
– Legendary trader Jesse Livermorea
The value of patience
In our experience, most investors get impatient and sell their fallen angels too early. If a stock doesn’t perform well within a year or two, the average investor tends to ditch it and never look back. But when you’re buying fallen angels, such behavior can be costly.
Some of the biggest winners we’ve profiled have floundered for several years before turning the corner. For example, Microsoft underperformed between 2005 and 2011, and every time we profiled the stock, our clients warned us that the Company was a classic value trap.
By 2011 Microsoft was selling for less than 10x earnings, an attractive valuation for one of the most dominant franchises in the history of corporate America—especially considering that it was still growing at almost 12% per year. That year it generated over $22 billion in free cash flow, which it used to buy back a tremendous amount of stock at bargain basement prices while also paying shareholders a generous dividend.
We could never have predicted that Satya Nadella would replace Steve Ballmer and revolutionize Microsoft, driving its share price up 17% per year from 2005 to today. But we did know that a statistically inexpensive company was still growing while maintaining a pristine balance sheet, generating an enormous amount of free cash flow, staying dominant in its industry, and buying back huge amounts of stock at attractive prices. We believed that if we were patient, either Wall Street would see what we saw or an activist investor would get involved and drive change.
Here are a couple stocks in our coverage universe that were once Wall Street darlings but that investors have left for dead. We’re not saying that they’ll be the next Microsoft, but we do believe that investors who buy them could be handsomely rewarded—if they have patience.
Over half a century ago, Medtronic pioneered the first wearable battery-operated pacemaker and commercialized the first implantable pacemakers. Over its more than 70-year history, acquisitions and R&D-supported organic growth have transformed the company from a small medical devices repair outfit into a broadline medical devices manufacturer. Today it is the largest medical device maker in the world by revenues.
COVID-19 was highly disruptive to the medical device manufacturing industry, stunting demand by reducing the number of patient hospital visits and medical procedures for conditions unrelated to the virus. Even after the shockwaves subsided, pronounced supply chain problems (lack of availability for semiconductors, medical dyes, and plastic trays for shipping surgical implements) hurt sales and margins. Medtronic’s recent financial performance has been lackluster (FY 2023 earnings dropped ~5%, to $5.29/share), leading to a steep ~40% share price retracement from the 2021 high.
Near-term guidance has been underwhelming (owing to pricing pressures in China and R&D outlays), below management’s longer-term target of >5% top-line and >8% bottom-line growth. However, for patient investors, there are reasons to be more optimistic about the future.
The company is refocusing its portfolio for higher organic growth and margins by investing in large and expanding markets like diabetes care (insulin pump systems), robotic-assisted surgeries, and pulsed field ablation (a method of treating atrial fibrillation with electrical pulses rather than traditional thermal [burning or freezing] methods).
Medtronic has recently resolved a warning letter with the FDA (regarding quality concerns surrounding a prior generation of diabetes insulin pumps), removing a major overhang on the shares, and has started selling its newest generation of insulin pumps in the U.S., which may provide unexpected upside in upcoming quarterly reports.
The ongoing rebound of elective surgical procedures should serve as a tailwind for several quarters. The company’s shares are inexpensive relative to its medical-device-maker peer group (P/E of 16.0x vs. peers at 26.0x) and offer a 3.4% dividend yield.
The Walt Disney Company was flying high prior to the pandemic, boasting healthy theme parks and movie businesses, with record-setting box office hits like 2019’s Avengers: Endgame (the second-highest grossing movie of all time).
When the pandemic hit, the Company’s theatrical distribution and theme park businesses ground to a virtual standstill. Yet its nascent streaming platform (Disney+ was launched in November 2019) benefited tremendously from rapid subscription uptake during this time. After a short-lived pullback, DIS shares soared in value, with the stock granted a premium valuation for its subscription streaming platform, not unlike the sky-high multiples Netflix has often traded for.
However, streaming profitability—rather than subscriber metrics—eventually became the sticking point on Wall Street, broadly sending shares of streaming businesses lower. Disney also made some missteps of its own that led to the removal of its CEO (and the return of prior CEO Bob Iger). Still, notable conundrums lie ahead, including CEO succession planning, what to do with ESPN (a transition toward a fully direct-to-consumer offering seems to be a question of when, not if), what to do with the linear television networks that have historically been a cash cow but that are quickly losing ground amid the ongoing “cord-cutting” trend, the likely upcoming purchase of the remaining stake in Hulu (Disney is contractually obligated to purchase the remaining 33% from Comcast in 2024, at a cost of ~$9 billion or more), and whether the writers/actors strikes will be resolved quickly.
Despite a rash of negative headlines, the company maintains some of the most valuable media IP in the world, which it adeptly monetizes throughout its vertically integrated channels. Moreover, it is making noteworthy progress on turning Disney+ into a profitable business. DIS shares are selling for less than 50% of their 2021 high and are even (mis)priced lower than they were at the depths of the March 2020 selloff, which we see as indications of overly bearish sentiment. With sustainable Disney+ streaming profitability anticipated to kick in in 2024, DIS shares may be priced quite differently down the road.
The bottom linel
It’s impossible to know for certain whether a company that has fallen out of favor with investors is a fallen angel or a value trap. But by doing careful research, identifying a catalyst that could spark a turnaround, and being patient enough to let such a turnaround develop, investors can profit from the second lives of companies that other investors have already left for dead.