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Software developers attend a BlackBerry 10 Jam in Kitchener, Ont., on Aug. 23, 2012. (Deborah Baic/The Globe and Mail)
Software developers attend a BlackBerry 10 Jam in Kitchener, Ont., on Aug. 23, 2012. (Deborah Baic/The Globe and Mail)

STRATEGY

RIM: How to bet on a broken stock Add to ...

Fabrice Taylor, CFA, publishes the President’s Club investment letter. His letter and The Globe and Mail have a distribution agreement. You can get a free copy here.

Unless you’re Prem Watsa, you shouldn’t be trying to catch the bottom on Research In Motion Ltd. stock.

Investing in what I call “broken stocks on the mend” is a great way to make a pile of money – my personal favourite. But it takes discipline and patience. You must accept that you will not catch the bottom – and that’s all right, because you can still hit a home run.

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Mr. Watsa runs Fairfax Financial Holdings Ltd. and he’s renowned as a value investor. One of his recent high-profile bets is on RIM: Fairfax owns about 5 per cent of the smartphone maker and he sits on the company’s board. It’s hard to know what his average cost is, other than to assume with a great deal of certainty that it’s higher than where the stock is now.

Mr. Watsa, like all big investors, has a tendency to buy stocks as they’re falling. Why? Because that’s when there’s volume. On the way down, when investors start to capitulate, a flood of shares come up for sale. For a big investor, who needs to buy a lot of stock, this is the time to jump in.

Should RIM turn around, fewer people will be interested in parting with their stock and it will be difficult to amass a large position without driving the price up. Big investors hate that.

But if you’re not a big investor, you don’t have this problem. You can bet on a RIM revival – on any busted company’s turnaround – in a way that gets you a nice return with less risk and less emotional trauma. After all, how many can buy RIM for $15 and watch it go to $6 without panicking and selling it? Not many of us.

Broken companies tend to follow a pattern. First, they stumble. Few investors, though, believe things will get really bad. The problems are temporary, they can be fixed, they tell themselves, comfortable in their denial.

The stock falls sharply, then rallies, then falls sharply, then rallies again. Meanwhile the news is getting worse and worse, but the devout hang in.

Eventually, some of the faithful lose their nerve and sell. They’re replaced by punters – investors who are attracted by falling share prices. They are usually the ones who didn’t buy the stock on the way up, or who sold too early and have been coveting the shares ever since.

Every tick down encourages these speculators to pull the trigger and they do. The stock rallies; they add more. You’ve seen this pattern in RIM for the past couple of years.

But these are not strong hands; they’re timid and insecure.

Consider RIM: Who was buying it as it climbed from $7 to $11 and why? There was no news other than that the company was closer to the launch date of its new operating system.

Most of the speculators who buy in at points such as this don’t have strong convictions about the stock. All it takes to clobber the share price is one analyst to opine that the company’s new operating system will be too little, too late.

So on the next downdraft, the punters lose their nerve and sell to the next gang of speculators.

The pattern repeats itself until the point of capitulation. How do you spot this moment? The stock flat-lines and the trading volume disappears. The hot money is gone; the ownership is level-headed and retail investors’ average purchase price is as close to the market price as it’s going to get.

That’s the bottom – assuming the company does turn itself around. But it’s not when you want to buy because, although the volatility is gone, it’s not clear that the company will make it.

At this point, now that reason prevails, you should let the market be your analyst. Watch the company’s earnings for a couple of quarters. If the stock starts to rise on little volume, odds are the turnaround is under way and you can roll up your sleeves and figure out if you want to invest.

By this point, of course, the stock will be higher – 50 per cent, maybe 100 per cent above the bottom. Fight the urge to say you missed it and walk away, because a broken stock’s price will multiply even from that point.

In RIM’s case, a real turnaround would take the stock to $60, at which point the company would likely be acquired.

In other words, if you want a great return with minimal risk, it’s never too late to wait.

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