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Thursday, July 28, 2011

Making Money by Investing in Poor Performing Companies

Sometimes, you can make more money by buying the least attractive stock in a particular industry if you believe the sector is due for a turnaround. Although it is counterintuitive, a little bit of simple math can show why it makes perfect sense and can leave the shrewd analyst with a much fatter pocketbook. These types of operations are for investors that have already built their complete portfolio and are on financially sound footing; they should not represent a substantial portion of your assets and are best left to those who have a good grasp of the economics and risks of the situation.

An Example in the Oil Industry

Imagine it is the late 1990’s and crude oil is $10 per barrel. You have some spare capital with which you wish to speculate. It is your belief that oil will soon skyrocket to $30 per barrel and you’d like to find a way to take advantage of your hunch. Ordinarily, as a long-term investor you would look for the company with the best economics and stick your capital in the shares, parking them for decades as you collected and reinvested the dividends. However, you remember a technique taught in Security Analysis and actually seek out the least profitable oil companies and begin buying up shares.

Why would you do this? Imagine you are looking at two different fictional oil companies:

• Company A is a great business. Crude is currently $10 per barrel, and its exploration and other costs are $6 per barrel, leaving a $4 per barrel profit.

• Company B is a terrible business in comparison. It has exploration and other expenses of $9 per barrel, leaving only $1 per barrel in profit at the current crude price of $10 per barrel.

Now, imagine that crude skyrockets to $30 per barrel. Here are the numbers for each company:

• Company A makes $24 per barrel in profit. ($30 per barrel crude price - $6 in expenses = $24 profit).

• Company B makes $21 per barrel in profit ($30 per barrel crude price - $9 in expenses = $21).

Although Company A makes more money in an absolute sense, its profit only increased 600% from $4 per barrel to $24 per barrel compared to Company B which increased its profit 2,100%. These differences are likely to be reflected in the share price meaning that although the first enterprise is a better business the second is a better stock.

More Information

Typically, these operations are most successful in industries that are dependent upon underlying commodity prices for their profitability such as copper producers, gold mines, oil companies, etc. The wild fluctuations in the underlying commodity can result in huge swings in the earnings of the business, making them good candidates. Of course, unless you are a professional, you should not engage in these types of transactions, instead focusing on building long-term wealth through value based, intelligent, and discipline investments that focus on getting the most earnings at the least risk.