Are You Bargain Hunting or Gambling?
Justin is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
What is the holy grail of investing? What is the one singular insight that can consistently lead to market-beating returns? This article isn’t going to uncover that great mystery, but it should provide a different viewpoint that may help an investor fully understand the risks they are taking. Often times asset classes are linked together and temporary divergences can create investment opportunities. One example is that the value of the dollar and the value of commodities are often inversely correlated. A fall in one leads to a rise in the other. Sometimes stocks in an industry rise and fall together, e.g. housing, and when one particular stock strays from the pack it may create an opportunity.
Most novice investors are infatuated with the price-to-earnings ratio and frequent stocks with low ratios. This year, dividend yield has risen to the forefront, and a higher yield can be mistakenly viewed as a relatively safe place for one’s money. Combine a low P/E ratio with a high dividend yield and it can at times seem like a value investor’s winning lottery ticket. But sometimes investors are taking a much bigger gamble than they realize. So what stocks give the illusion of being a bargain but in fact are a big gamble?
To answer this question, we turn to the credit default swaps market (CDS). CDS are over-the-counter instruments that came to notoriety during the Global Financial Crisis. They can take many forms and are an agreement between two parties that can be constructed to fit any need. This specific focus is the CDS of public company bonds. Investors will buy CDS as insurance against bond defaults. If the CDS level is rising then investors are paying more for insurance and fear higher default probabilities. The most popular term length is five years and our focus here. Often times, but certainly not always, action in the bond market leads that of the equity market. Spreads will widen and CDS levels will rise before a stock starts to peak and roll over.
The table below shows two companies that might sound like great “value” plays. They have cheap valuation, good dividends yields, and are industry leaders.
Best Buy (NYSE: BBY) still remains a leader in the electronics retail space, but performance has been on a steady decline since their 2006 peak. Amazon didn’t pass Best Buy in sales until this year and Best Buy still generates close to $50 billion in annual sales. The company’s same store sales have turned negative and a reversal seems difficult given the competitive landscape. Sales per square foot peaked in 2006 at $984 and now reside at just $861. So the stock is down for good reason. But at -79% from its peak, one would think the difficulties have been priced in. Is Best Buy a value investor’s dream?
More like a coin-flip gamble. The 5-year CDS level currently resides at over 1,000 basis points. Without getting into the details too much, investors are paying five times more for insurance on Best Buy bonds than they were two years ago. And the implied probability of default within the next five years is 61% at current CDS levels (Bloomberg). So while Best Buy looks like a bargain, the credit markets are raising red flags. A 5% dividend yield won’t compensate for a bankruptcy event, if it were to happen in the next five years. The possible outcomes on Best Buy are looking more binary: either a recovery and big upside gains or total loss for equity investors. Investors not comfortable with this situation should avoid the stock.
Which company is the industry leader in global PC sales? That would be Hewlett-Packard (NYSE: HPQ). The secular shift may be toward more portable devices, but Hewlett-Packard is a heavyweight in the industry. The current stock price would not give that indication. The company recently disclosed that it will be forced to write-off the majority of its $11 billion purchase of Autonomy. Forward guidance has been slashed and visibility on a turnaround is murky at this juncture. Sales and margins are moving in the wrong direction. Is this beaten-up stock a safe play for an investor to earn a dividend yield that exceeds investment grade corporate bonds AND be privy to notable capital appreciation at some point in the future?
The CDS market would indicate investors get a firm grasp that bankruptcy is a plausible outcome. While certainly not in the dire position of Best Buy, Hewlett-Packard CDS levels have tripled in the last eighteen months and are pricing in a 23% chance of bankruptcy at some point in the next five years.
Best Buy and Hewlett-Packard are two of the more risky plays despite their appearance to the contrary based solely on valuation and dividends. While the CDS market can raise red flags, it can also offer a bit of guidance on the long-term health of certain companies.
One such company is Intel (NASDAQ: INTC). While also a victim of slower PC sales, Intel would be the safer name to own. The company holds a dominate 80% share in the PC microprocessor market. The stock has been deadweight as the company looks to transition and gain share in the tablet market amid near-term softness in the PC market. But the 4.4% dividend yield is supplemented with a single-digit P/E ratio, a 5-year compound annual growth rate of 14% in the dividend rate, and a payout ratio of just 37%. A CDS level of 70 implies default likelihood in the next five years of just 7%. Bargain hunting equity investors may prefer the SAFETY and upside Intel offers.
Is there a company that offers one of the lowest CDS levels among all bonds, trades with a P/E ratio below that of the market, and has a favorable dividend yield? The answer is YES. Norfolk Southern’s (NYSE: NSC) CDS level of 37 (and implied default likelihood of 3%) is one of the lowest among all bonds for which there is a market. The favorable credit backdrop lays the foundation for risk management. The 11x P/E ratio is well below the market average. The yield is a solid 3.2% and payouts have grown at a 15% rate over the last five years. The payout ratio of 39% leaves ample room for sustained dividend growth.
The Foolish Bottom Line
Investors may want to look at credit markets before diving headfirst into beaten down equities. Sometimes the risks are just too great, and certain securities are more akin to gambling, even if they are former blue-chips. This is the current situation for Best Buy and Hewlett-Packard. Only the riskiest of investors, those with a firm grasp of the plausibility of bankruptcy, should venture into these two securities. Most investors will find it very hard to stomach owning a company that files for bankruptcy. If this is you, then favor companies with solid credit fundamentals that also offer favorable valuation attributes as well. Two examples, but certainly not the only ones, include Intel and Norfolk Southern.
market8 has no positions in the stocks mentioned above. The Motley Fool owns shares of Best Buy and Intel. Motley Fool newsletter services recommend Intel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!