Getting Stuck

By Bob Wood

A couple weeks ago, stock markets around the world took a nasty fall. And on the most volatile trading days, when trading volumes on major exchanges reached new, all time records, investors set records for making changes to their accounts. Of course, some people with day jobs may have lamented getting stuck with holdings they might have sold — if they had been able. But I am not sure their staying put was such a bad thing.

As an investor who looks far and wide for opportunities missed by the crowds, I find “getting stuck” with some holdings is a rather regular phenomenon. Those who hold a few thousand shares of a stock trading in very limited amounts on a typical trading day find that “getting stuck” is not unusual. And perhaps this is the major reason that most investors, individuals and professionals alike, won’t buy relatively illiquid stocks. It’s much easier to sell positions in heavily traded shares like Microsoft, Intel or 3M than to sell quickly some of the shares sitting in my portfolios.

So when trouble hits, “getting out” becomes the major objective of the typical investor. Fueling this mindset are financial media outlets, which announce daily ‘’the start of trading’’ when the markets open, as opposed to the ‘’start of investing.’’

Let’s imagine that, after a long day at work, you discover the markets had taken a dive, and one of your stock holdings sold off dramatically. If you had used a strict set of criteria when buying, perhaps you need not become so alarmed. An investor who thinks “long-term” accepts such declines as part of the game – and nothing more.

An example of how this situation occurs involves shares in one of my “oddball” favorites, Grupo Casa Saba (SAB), mentioned previously in this column. As I write this column on Friday at 1:30 p.m., today’s total trading volume on SAB has risen to — 100 shares! Yes, one hundred shares have traded today. Did I mention that the stock is illiquid?

According to “Yahoo Finance,” the average volume on this stock runs about 3,300 shares/daily. So when markets fall hard, as they did in early March, what could I do with a few thousand shares of SAB? Maybe I should have considered this point when buying the shares, right? Trying to sell more than one day’s average volume of shares could easily result in my moving that share price down – all by myself!

Lucky for me, though, I did consider liquidity when I bought those shares for several client accounts. I knew full well that SAB was not followed by analysts, and only one mutual fund tracked by Morningstar holds the company’s shares. Yet this stock is far from an outlier in my client accounts, since I purposely look for stocks that don’t appear on other investors’ radar screens. How else can I find undiscovered, under-valued gems in today’s environment of 8,000 mutual funds, that many hedge funds and hundreds of other large institutional investors in an era of unprecedented liquidity?

Anyone expecting to make money buying stocks that appear daily on the most-actively-traded lists is surely mistaken. The great investors of our time, like Warren Buffett, preach that going your own way and doing what other investors do not, or will not, do is the best way to profit from investing. And that means driving down the road less traveled, which, to me, means buying what most others will not. How else can I find stocks that are not already fully priced?

I have other favorites that trade in small numbers, and I may well get stuck with them when markets endure another rough spell. I’ve mentioned some before, such as Industrias Bachoco (IBA) and closed-end funds like the Alliance World Dollar Fund (AWG), Latin America Discovery Fund (LDF) and Asia Pacific Fund (APB).

But I didn’t buy these shares to trade them. I bought them to hold — for a long time. I bought them as investments. Based on my own version of fundamental analysis, I found them too good to pass up, regardless of how easily I may or may not be able to sell them. I knew full well when I hit the “buy” button that I was going where few others dared to go. And this rationale works for holding gold shares, too.

For me, the case for buying these lesser known names is too compelling. And the real excitement comes with considering what these investments could be worth many years from now. Short-term volatility, and nothing more frightening than that, is just part of the deal. And remember, Buffett says that his favorite holding period for one of his positions is forever. That point illustrates the lost art of investing, which has been overtaken by the chase for short-term profits or technical trading methods, which are so prevalent today.

The fact that most ignore the art of fundamental analysis can take some of the blame. And, of course, this type of investing requires a different kind of mindset. If investors considered a potential stock as one to hold patiently for at least five years, they would consider it much more carefully before hitting the “buy” button.

What I look for is not a rapid exit strategy to control potential losses but, instead, a simple rationale for how I expect to be re-paid for risking valuable cash. When I look at the most actively traded technology shares like Intel, Applied Materials, Cisco, Yahoo! and others, I just don’t see any assurance of getting a fair return if markets perform badly. These stocks don’t pay dividends and are in brutally competitive industries where products are rapidly commoditized. The best hope for making a profit is that someone else will pay more than you did originally.

But when markets head down, your dream of selling higher can evaporate quickly. Of course, you could hope that a private equity firm sees enough value imbedded in one of the companies to buy the whole thing. But with shares of Intel, for instance, selling at close to 20 times trailing earnings (our most reliable metric), how viable is that hope?

But a stock selling at that ratio offers an owner of the entire company a 5% return on his investment in the first year, along with the risk of loss in the shares in a down market. And how many smart investors will take that kind of risk to their initial investment for a 5% return? I’m guessing not many would, so the holder of those shares could indeed be stuck – with a loss.

In the case of SAB, the largest distributor of wholesale pharmaceutical, beauty and health care products in Mexico, the future looks much better. Think of the trucks arriving to stock the shelves at night in your local drug stores. This is what I would call a business with a tough barrier for new entrants.

This stock sells for about 13 times earnings, and that’s after a strong run over the past few months. Should the shares hold steady at today’s price, a buyer of all shares taking the company private would realize close to an 8% return in the first year – a not-great but still not-too-bad return. If the shares fall from today’s price of about $34, that return rises.

Looking at the company’s recent financial statement shows its market capitalization at about $900 million. That’s what it would cost someone to buy the entire company and take it private. But when sitting in the CEO’s chair, the new owner would notice about $300 million in cash on his balance sheet and no long-term debt. So the rebate of that much cash would reduce his outlay to about $600 million. The company’s net earnings for last year were about $70 million, which would show the new owner a first-year return of about 12%. Hey, that’s not bad, — and in just the first year!

Since this company is certainly a slow grower in terms of sales and earnings, let’s anticipate a rather tepid 4% growth in earnings for the next 10 years. In 10 years the company’s earnings would come close to $100 million/year, which, compared to the original net investment of $600 million, doesn’t look too shabby. Of course, after 10 years of ownership, our courageous investor has realized nearly $850 million in net profits, assuming all goes as planned, which is always unknown in advance.

So how badly do you think this investor would fare, having had a hard time selling his shares and getting stuck “holding the bag,” so to speak? I am guessing that worse things that could have happened. And I think worse things can happen to my clients who are “stuck” with those illiquid shares, which are now climbing to the top of several accounts after the recent surge in share price. As for commodities like gold and silver, has there ever been a better long-term investment? And I mean over the past 100 or 1,000 years?

I know full well that I could get stuck in these lesser known stocks. But by knowing this up front, I consider myself more careful than most when buying. If all investors looked at purchases this way, getting stuck wouldn’t be such a bad thing. And far fewer would be going anywhere near those far more actively traded stocks.

Before you buy shares in any stock, think what would happen if you couldn’t sell them quickly. If nothing else, your criteria for buying them should look more like an investor’s — not a trader’s.

Remember one important caveat here. I am not advocating that you run out and load up on this stock. I could try to sell it at any time without disclosing that here. If you buy it, you’re on your own!

Have a great week.
Bob

Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., invest@muslimobserver.com.
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