If you are a long-term investor, it usually provides opportunity than hardship when an investment you own is undervalued—i.e. selling for less than it is properly worth. If a business is worth $70 per share and yet it trades for $50 per share, there are two levels that can be pulled on behalf of shareholders to create value.
First, the management team could repurchase some of the company’s stock, which assuming the estimates of the business’ value are accurate, results in the creation of a 28% return as long as that status quo differential persists. And secondly, the management team can declare a dividend, which the shareholder can then choose to reinvest into more ownership shares that are trading at the projected 28% discount. This type of perpetual undervaluation is a not insignificant portion of the long-term wealth that owners in the old Abbott Labs, Philip Morris, and Standard Oil were able to receive over the decades.
But there is one risk that comes with the territory of undervalued companies. If a deep yet momentary financial crisis hits, there is the possibility that a prospective purchaser of the entire business could buy out the business for dimes on the dollar, permanently locking in your end return point.
For example, consider this hypothetical. Imagine in 2007 you evaluated Aflac as a potential investment. You looked back and saw that, from 1982 through 2007, the investment had delivered annual returns of 14.5% per year, thoroughly trouncing the market over that time by almost five percent per annum. Then, you looked at the reasonable P/E ratio and saw a trailing ten-year earnings per share growth record of almost 11%. You could have seen the stock trading at $68 per share and reasonably calculated that it was worth around $85 per share.
You did everything right. You studied the investment, made a purchase at an attractive price point, and then committed for the long term. And yet, by 2009, Aflac fell to almost $10 per share even though its annual profits were still growing by a double-digit rate. You chose a great investment that was now being grossly, fantastically undervalued by Mr. Market.
The reality was that, by 2013, the stock recovered from the 2009 lows and once again traded in the upper $60s. But nevertheless, a risk manifested itself during that $10 pocket of time when one of Aflac’s competitors or a deep-pocketed investment outfit could have done something like make a $20 per share offer to buy out the company. If that were to happen, you would permanently locked in a loss of 60-70% even though you correctly analyzed the business and identified the fortunes that awaited ahead.
The defense mechanisms against this risk are that the management team is free to say no to takeover offers that exceed the prevailing stock market price of the business. And even if they say yes, many transactions are subject to shareholder approval and/or shareholder lawsuits for breach of fiduciary duty if the purchase price accepted for the takeover is too low (though this latter option requires a high burden of proof and is therefore unlikely to succeed). Outside of management, your best remaining is diversification and the knowledge that this risk only materializes to a fraction of mid-cap and large-cap stocks two or three times per century.
Originally posted 2018-08-17 01:20:45.