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Behind the Numbers

Bargain hunters see beauty in the most pug-ugly places Add to ...

We are here today to celebrate the three best friends of any value investor - ugliness, apathy and fear.

Negative emotions are what drives a stock into bargain territory. You won't find cheap deals among the market's best-loved companies. But if you look for ugly companies, ringed in by fear and surrounded by apathetic investors, you just may find a deal that has yet to catch the eyes of the market.

One of the smartest private investors I know likes to say that people love his results but hate his portfolio. It's stuffed full of companies in declining industries, one-time stars that have fallen on hard times and boring firms that put most investors to sleep. Yet this collection of pug-uglies regularly posts double-digit returns.

The key, of course, is buying these less than impressive firms at prices that are even lower than their prospects warrant. That involves ignoring the prevailing sentiment and taking a cold-eyed look at fundamentals.

What companies have better fundamentals than their reputations suggest right now? Let's start with BP PLC , the firm that nearly turned the Gulf of Mexico into a giant oil slick, then infuriated the public with its ham-handed treatment of the disaster. It keeps bumping up its estimate of the cost associated with the Macondo spill and now pegs the hit at nearly $40-billion (U.S.).

BP won't win awards for environmental stewardship any time soon, but from an investor's perspective, this ugly oil giant holds intriguing potential. Since earlier this year, the market has cut about $50-billion off BP's market capitalization, suggesting that investors have more than fully accounted for the costs of the spill.

Granted, those costs are a moving target and could soar if BP is found to have been grossly negligent. But since it's in the company's best interests to minimize its profits while it's under scrutiny, it's not unreasonable to think that its reserves for spill-related costs may be on the high side.

If you peer beneath the surface of the financial statements, a quiet recovery appears to be in the works. Excluding spill costs and other items, the company's most recent results showed an 18-per-cent gain in underlying profit. The balance sheet is strong. If BP can regain something approaching its pre-spill profitability, it's cheap. Ugly, too, of course. But cheap.

To illustrate the merits of apathy, let's choose - yawn - Dell Inc. , maker of anonymous beige computers. The one-time high flier has been in a three-year slump and now trades for half the price it did in 2007. Its products don't excite consumers and margins are dwindling as personal computers become commodities.

So what might shake investors out of their apathy? One positive factor is Dell's growing "solutions" business in which it sells servers, storage and services to corporations. That business now accounts for more than a quarter of Dell's revenues and over half of gross profits, according to Staley Cates of Southeastern Asset Management, which has a large position in the stock.

Dell still gushes cash and, while it may never regain its former lustre, odds are that it can continue to claim a large slice of the consumer market while building up its solutions business. Mind you, it's not an exciting stock - and that's precisely the point when you're trying to exploit pockets of apathy.

And that brings us to fear. Sometimes investors put the emphasis on the negative when assessing a company. A good case in point is Fairfax Financial Holdings Ltd. of Toronto. (Full disclosure: I'm a shareholder.) This property and casualty insurer trades for slightly less than book value and under 10 times trailing earnings, despite a recent record of strong results.

Investors don't like Fairfax's complicated accounting, its appetite for risk, and its history of large and unpredictable swings in profitability. A decade ago, its results were hammered by bad acquisitions in the United States. Short sellers assailed its management and reputation. Then the company turned the tables on its critics by investing in credit default swaps linked to the collapse of the U.S. housing market. The bet proved to be spectacularly right.

An investment in Fairfax isn't for the timid. To a large degree, it's a gamble on the investing acumen of Fairfax's chairman, Prem Watsa. But Mr. Watsa's mostly stellar record over the past two decades suggests he deserves the benefit of the doubt. Meanwhile, his firm looks cheap on all the major valuation metrics. The fear around the stock appears overdone.

So there you have it - three stocks chosen to display the virtues of ugliness, apathy and fear. We'll check back in a year to see how this trio performed.



Follow on Twitter: @IanMcGugan

 

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