Beaten-down stocks often make the best value investments.
“The time to buy is when there’s blood in the streets,” said Barry Rothschild, an 18th century British nobleman and banker.
Or, as Warren Buffett put it in more modern and far less graphic terms, “Be greedy when others are fearful.”
But not all beaten-down stocks are created equal. For evidence, I present you the cases of Chipotle (CMG) and Yahoo (YHOO).
Both are well-known, somewhat iconic companies that have fallen on hard times of late. Chipotle is in the midst of a full-blown E. coli outbreak; the fast-food giant was forced to close 43 restaurants in nine states after diners contracted the bacteria-based illness from eating their food. To make matters worse, this week 141 Boston College students (including more than half the men’s basketball team) got sick from eating at a Boston Chipotle after contracting a different virus, something called norovirus. Yikes.
Needless to say, CMG stock has been tanking since this series of outbreaks began; the stock is down 24% in the last two months.
Yahoo’s problems haven’t been as embarrassing or egregious as an E. coli outbreak. But the company’s earnings have been on steady decline for the past two years under CEO Marissa Mayer, as Yahoo has clearly fallen well behind competitors Google and Facebook. Yahoo’s recent struggles prompted the company to announce this week that it will restructure its core business and spin off into two companies, and have put Mayer’s job in jeopardy.
Amid all that instability and dwindling growth, YHOO stock has plummeted more than 31% this year.
So, both CMG and YHOO qualify as beaten-down stocks. But only Chipotle looks like a possible value candidate.
Chipotle’s bad news is humiliating, but it hasn’t had a profound impact on sales, and probably won’t in the long term. Sure, some people will swear off the restaurant completely—and surely those poor souls who contracted E. coli or norovirus will never return. But the vast majority won’t; in a few months, the outbreak will be yesterday’s news. That’s the reality of this 24-hour news cycle.
Chipotle essentially poisoned diners in 10 states, but it doesn’t change the fact that the company’s sales (12% growth in the third quarter) and earnings (10.6%) are still growing at a healthy rate. Those quarterly results are roughly in line with the company’s full-year 2015 sales and earnings estimates. That’s slower growth than a year ago (sales expanded 28% in 2014, EPS improved 35%), but it’s growth nonetheless.
That’s why our value expert and Cabot Benjamin Graham Value Investor advisory editor Roy Ward still lists Chipotle as one of his “Top 275 Value Stocks” in his latest issue. With a P/E of 33, however, Roy wants to see CMG fall even further—ideally another 26%—from its current $567 share price before recommending it as a strong value play. But he does note that Chipotle is a “fast-growing company with a strong balance sheet and solid earnings.”
The same can’t be said for Yahoo. It doesn’t make Roy’s list.
Why? For one, Yahoo’s recent stretch of bad news actually stems from slowing sales and earnings growth. Revenues have been on a steady downslide since 2008, from $7.2 billion that year to an estimated $4.9 billion this year. Meanwhile, the company’s per-share earnings haven’t grown since the third quarter of 2014.
Things could only get worse next year. Sales and earnings are expected to slip even further in 2016. Thus, even with YHOO stock down 31% in 2015, it’s still well overvalued: the stock trades at an extremely frothy 133 times trailing earnings, and 59 times next year’s earnings estimates.
Those aren’t the makings of a promising value stock, even if the company’s restructuring plan works and Marissa Mayer rights the ship. You can’t invest solely on promises. Any play on YHOO stock at the moment would be little more than speculation.
As Roy says, “Yahoo will need to reinvent itself before I add it to my universe of stocks.”
Yes, some beaten-down stocks can make for great investments. That’s why you shouldn’t rule out Chipotle after its recent string of disease-ridden embarrassments. But the reasons why the stock is so beaten down do matter, and so do the fundamentals.
A growing company with a beaten-down stock can make for a good value stock; a beaten-down stock with declining sales and earnings probably isn’t worth the risk.
As Mr. Buffett can probably attest, sometimes the fear is warranted.