Thursday, April 24, 2008

Biggest losers

I'm constantly amazed by the irrationality of the stock market. (Of course, the market seems irrational when my stocks are going down and I'm a genius when they go up!) My two biggest losers are priced far below what my DCF models predict they are worth. First Marblehead is fairly easy to figure, since the company publishes projected cash flows from its residuals. If you discount those residuals at 15%, which is greater than the rate management uses to value any of the residual tiers, the stock ought to be trading no less than $6 a share. That would imply no future business, which is a safe assumption at the moment. The current price ($3.62) implies a discount rate of 23%, which is what you might be charged for credit card debt if you had a really bad credit score. Remember, these loans can not be discharged in bankruptcy and were originally made to people with relatively good credit scores. First Marblehead will almost certainly double in price when the cash from residuals begins rolling in during 2009. Also, the shares have a built in call option on the possibility business will resume in the future.

Select Comfort, as a consumer products company that is currently out of favor with consumers, represents a tougher challenge to value. There's no way to know if the Sleep Number concept has run its course and sales will whither and die. But if we assume that the company will earn 22¢ in the next 12 months as it did the last 12 months and that earnings will increase a modest 3% forever, you get the current market value. But there are reasons to expect these assumptions are too modest. First, the company has finally stopped building new stores and buying back shares, and has cut advertising, staff and other expenses. Earnings in the future figure to be higher even if sales remain flat. Second, if the market ever turns Select Comfort would seem poised to capture quite a bit of market share. It's severely cut back advertising, which has hurt the wholesale and online portions of the business. When people start buying mattresses again, it should face fewer competitors with less capacity.

Now these companies have very little risk of becoming worthless and if things go right ought to do very well. At these prices, simply returning to profitability will provide new investors with great returns. I've already lost most of my investment in these companies and I can't afford to put more cash into them. But I will continue to hold them, which is functionally the same as considering them good buys, because the upside remains more likely and more profitable than the downside. As Mohnish Pabrai says, "Heads, I win; tails, I don’t lose that much."

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