Beating the Street (35 page)

This was a company with warts. Its greatest virtue was that the stock price had fallen from $9 to $1.25 in the summer of 1991. It was involved in software and consulting—one a high-tech business that I found incomprehensible and therefore untrustworthy, the other too vague for comfort. Its biggest clients were the nuclear power industry and contractors to the federal government.

A couple of phone calls, and I knew why the stock price had collapsed. The company was squabbling with one of its major sources of revenue: the feds. The feds were accusing Tenera of overcharging it for certain services, and had canceled some contracts. Worse than that, a software program, which cost millions to develop and which Tenera hoped to sell to electric utilities around the world, was not paying off.

The company was forced to cut its work force drastically. Some key executives, including the president, Don Davis, had resigned. For those that remained, the atmosphere was far from harmonious. Tenera's competitors in the consulting business were bad-mouthing Tenera to its customers.

In June 1991, the dividend was canceled. The company announced that it would “take a long time” to restore it to its former level of 20 cents a quarter.

I don't mean to tout Tenera too highly. If this company had had even a dime worth of debt, I wouldn't have given it a second's worth of attention. Since it had no debt and no large expenses to pay, I figured it wasn't going out of business in the next day or two. These were the positives: zero debt, no capital spending to speak of (what do consultants need, except for a desk, a calculator to add up their fees, and a telephone?), and a well-regarded nuclear services division that could be sold at a profit in a liquidation.

Tenera had earned between 77 and 81 cents a share in each of the four years prior to 1991; it still had earning power. Maybe it would never reach 80 cents again, but if it earned 40 cents, the stock might be worth $4.

With conditions as desperate as these, I wasn't counting on earnings. I was counting the potential value of the assets as spare parts. I figured a Tenera on the auction block was worth more than $1.50 a share (the price at the time I did this analysis), and with no debts and expenses, the entire amount minus the legal fees would go to the shareholders.

If the company solved some of its problems, the stock would make a big rebound, and if it didn't, the stock would make a small rebound. That, at least, was my expectation.

Tenera had brought in Bob Dahl, a guy I'd met when he worked in the telecommunications industry, to oversee the recovery. Dahl reached me in New York the night before the
Barron's
panel. He suggested that a turnaround of the company's operations was possible within the next 6–12 months. He also said that insiders were holding on to their shares. This convinced me there was still some value in the company.

What Goes Around Comes Around

When the economy is in the doldrums, the professional money manager begins to think about investing in the cyclicals. The rise and fall of the aluminums, steels, paper producers, auto manufacturers, chemicals, and airlines from boom to recession and back again is a well-known pattern, as reliable as the seasons.

What confuses the issue is the fund manager's perpetual itch to get ahead of the competition by returning to the cyclicals before everybody else does. It seems to me that Wall Street is anticipating the revival of cyclical industries earlier and earlier before the fact, and this makes investing in cyclicals a trickier and trickier proposition.

With most stocks, a low price/earnings ratio is regarded as a good thing, but not with the cyclicals. When the p/e ratios of cyclical companies are very low, it's usually a sign that they are at the end of a prosperous interlude. Unwary investors are holding on to their cyclicals because business is still good and the companies continue to show high earnings, but this will soon change. Smart investors are already selling their shares to avoid the rush.

When a large crowd begins to sell a stock, the price can only go in one direction. When the price drops, the p/e ratio also drops, which to the uninitiated makes a cyclical look more attractive than before. This can be an expensive misconception.

Soon the economy will falter, and the earnings of the cyclical
will decline at breathtaking speed. As more investors head for the exits, the stock price will plummet. Buying a cyclical after several years of record earnings and when the p/e ratio has hit a low point is a proven method for losing half your money in a short period of time.

Conversely, a high p/e ratio, which with most stocks its regarded as a bad thing, may be good news for a cyclical. Often, it means that a company is passing through the worst of the doldrums, and soon its business will improve, the earnings will exceed the analysts' expectations, and fund managers will start buying the stock in earnest. Thus, the stock price will go up.

The fact that the cyclical game is a game of anticipation makes it doubly hard to make money in these stocks. The principal danger is that you buy too early, then get discouraged and sell. It's perilous to invest in a cyclical without having a working knowledge of the industry (copper, aluminum, steel, autos, paper, whatever) and its rhythms. If you're a plumber who follows the price of copper pipe, you have a better chance of making money on Phelps Dodge than the M.B.A. who decides to put Phelps Dodge in his portfolio because it “looks cheap.”

My own record with cyclicals is moderately good, and whenever there's a recession I pay attention to this group. Since I always think positively, and assume that the economy will improve no matter how many bleak headlines appear in the papers, I'm willing to invest in cyclicals at their nadir. Just when it seems that things can't get any worse with these companies, things begin to get better. The comeback of a depressed cyclical with a strong balance sheet is inevitable, which brings me to Peter's Principle #19:

Unless you're a short seller or a poet looking for a wealthy spouse, it never pays to be pessimistic.

We've already discussed how I was foiled in my attempt to get in on the rebound in the housing market by purchasing the home builders' stocks—too many other buyers had beaten me to those. But they hadn't yet anticipated the rebound in the copper market, and it was hard to ignore the bargain that appeared before me in January
1992 in the form of Phelps Dodge. I checked with my plumber, and he confirmed that the price of copper pipe was going up.

Phelps Dodge was a stock I'd recommended in 1991, and it hadn't gone anywhere the entire year. A stock's having gone nowhere is not necessarily a reason to ostracize it, and it may be a reason to buy more. On January 2, 1992, I reviewed the Phelps Dodge story, and it sounded even better than it had a year earlier.

I used to visit Phelps Dodge in New York, but since it relocated to Arizona, we communicate by telephone. I called the company and talked to the chairman, Douglas Yearly.

From earlier flirtations with this company, I'd learned a few facts about copper that convinced me it was a more valuable commodity than, say, aluminum. There's a lot of aluminum in the earth's crust (8 percent, to be exact), and not only is aluminum as common as tumbleweed, it's relatively easy to extract. Copper is scarcer than aluminum to begin with, and it's a vanishing asset. Mines run out of copper or get flooded and are forced to close. It's not like the assembly line for Cabbage Patch dolls, where you can get more Cabbage Patch dolls by adding another shift.

Environmental regulations have forced the closing of many of our nation's smelters, and many companies have given up smelting for good. There's a smelter shortage in the U.S. already, and one is developing worldwide. People who live downwind of smelters can breathe easier because of this trend, and so can the shareholders of Phelps Dodge. Phelps Dodge has plenty of smelters, and not nearly as many competitors as it had before.

Although the demand for copper was slack in the short term, I figured it was bound to pick up. All the developing nations of the world, including the many spin-offs from the old Soviet Union, are dedicated to improving their phone systems. Everybody wants to be a capitalist these days, and it's hard to be a capitalist without a telephone.

A traditional phone system requires miles and miles of copper wire. Unless all these start-up countries opt for a cellular phone in every pocket (a strategy that's unlikely), they are going to be frequent buyers in the copper market. Developing countries are much more copper intensive than mature countries, and the preponderance of the former bodes well for the future of this metal.

Recently, Phelps Dodge stock had followed the typical cyclical pattern. In 1990, before the recession, the company earned $6.50
(adjusted for a recent split), and the stock sold in a range of $23-$36, giving it a low p/e ratio of between 3.5 and 5.5. In 1991, earnings dropped to $3.90 and the stock price retreated from its $39 high back to $26. That it didn't retreat further is evidence that many investors thought highly of this company's long-term prospects. Or perhaps the cyclical players were betting on the next cycle earlier than usual.

The most important question to ask about a cyclical is whether the company's balance sheet is strong enough to survive the next downturn. I found the information on page 30 of the 1990 Phelps Dodge annual report, the most recent I could get my hands on at the time. The company had equity of $1.68 billion and total debt (minus cash) of only $318 million. Clearly, this was no candidate for bankruptcy no matter what the price of copper (well, zero would be a problem). Many weaker competitors will be forced to close their mines and pack up their slag and go home before Phelps Dodge even has to refinance.

Since this is a big company, and since it had diversified into many industries besides copper, I wanted to see how those other businesses were doing. The CEO, Yearly, went down the list: carbon black was OK, he said; magnet wire was OK, truck wheels was OK, and Canyon Resources, the Montana gold mine discovery in which Phelps Dodge has a 72 percent interest, could become a big moneymaker.

These subsidiary enterprises earned less than $1 a share in a bad year (1991), and it was not farfetched to assume they could earn as much as $2 in a decent year. Assigning them a modest p/e ratio of 5–8, I concluded they might be worth $10-$16 a share on their own. The gold operations could be worth $5 a share to Phelps Dodge.

I often do this sort of thumbnail appraisal of a company's various divisions, which may represent a sizable hidden asset. This is a useful exercise to perform on any sort of company whose shares you might want to buy. It's not unusual to discover that the parts are worth more than the whole.

It's easy enough to find out if a company has more than one division—the annual report tells you that. It also gives you a breakdown of the earnings. If you take the earnings of each division and multiply by a generic p/e ratio (say, 8–10 for a cyclical on average earnings, or 3–4 on peak earnings), you'll get at least a rough idea of how much the division is worth.

TABLE 15-1. CONSOLIDATED BALANCE SHEET—PHELPS DODGE CORPORATION

(dollars in thousands except per share values)

In the Phelps Dodge exercise, if the gold mine was worth $5 a share, the other ancilliary divisions were worth $10-$16 a share, and the stock was selling for $32, you were getting the copper business for very little.

I also looked at capital spending, which is the ruination of so many industrial companies. This didn't appear to be a problem at Phelps Dodge. In 1990 it spent $290 million to upgrade its plants and its equipment, less than half its cash flow.

Page 31 of the 1990 annual report (see
Table 15-2
) shows a cash flow of $633 million, which exceeded capital spending and dividend payments combined. Even in a bad year, 1991, cash flow exceeded capital spending. It's always a good sign when a company is taking in more money than it spends.