The art of catching a knife

In February, J.C. Penny (NYSE: (JCP)) performed well. True, this stock is extremely volatile right now and not paying dividends (two points of concern for me). Still, in my opinion, J.C. Penny is on the right track for recovery, and that the stock may appreciate later this year or in 2015. This is an investment I plan to have long term, and I’ll be patient enough to wait for a turnaround.

At different moments in time, companies face serious challenges – sometimes they fail, sometimes they succeed. The key for investors is to identify the companies that can pull it off versus those that will fail.

A simple example of this is the story of Apple (AAPL) vs. the story of Palm. In the mid 90’s, Apple was no longer a technological leader. In fact they were struggling just to stay afloat as the company lost money throughout of 1994, 1995, 1996, and 1997.

The first quarter of 1997 marked a nadir, as Apple’s stock hit a 12-year low of $4, and the company reported a $708 million loss. At the time nobody wanted to hear about Apple stock, but it turned out that those who chose to invest would be rewarded with a 13,209% increase in 17 years.

As we now know, Apple was one of the companies that could pull it off. Don’t get me wrong, identifying these companies is not easy. If it was everyone would be making a fortune in the stock market.

It requires a deep understanding of the economy, the environment in which the company operates, market trends, competitors, and more than a little bit of intuition.  Companies on the verge of collapsing is like catching falling knives that only smart value investors with a lot of courage and instinct can take advantage of.

The other side to this story is the story of PALM, which was acquired by Hewlett-Packard (HPQ) back in 2010.  PALM turned out to be a cautionary tale of a company in dire straits that didn’t have the resources necessary to succeed, operating in a hostile ever-changing environment, and making one bad decision after another.

PALM created the first broadly adopted PDA (personal digital assistant) in the world, and was very successfully for a short while. Palm Inc. had its IPO during the dotcom bubble and on its first day of trading shares of the new company hit an all-time high of S$95. However, this success was short lived – increased competition and the bursting of the tech bubble caused Palm’s shares to lose 90% of their value in just over a year.

By June 2001, the company’s shares were trading at US$6.50, making it the worst performing PDA manufacturer on the NASDAQ index at the time. After a series of events including a merger with Handspring in 2003, PALM’s stock surged back up to $18 in 2009, coinciding with the hype over WebOS.

While reviews of the Palm Pre generally were positive, the decision to launch the product with only one U.S. carrier (Sprint) proved to be a crucial mistake that limited sales, and ultimately wasn’t enough to keep the company alive.

At the time they had only $250 million in cash and no financing in sight. In 2007, Palm was facing fierce competition from Apple and Windows phones. It was a much smaller company and made several critical mistakes at the worst possible time.

Nobody was interested in the survival of PALM and the company was not diversified enough to pull off a turnaround. By 2010 the share price of Palm dropped to below $4 USD, and in April 2010 PALM was finally delisted from the stock market after their acquisition by Hewlett-Packard.

Catching knives is only risky if you don’t know what you are doing. If you know what you are doing it can be very rewarding in the long run. Obviously, I don’t have a crystal ball but, I think, J.C. Penny is a company that is currently struggling big time, but it is also not a company that will disappear anytime soon.

The current transition out from the last economic crisis is called “deleveraging.” Deleveraging can be achieved by cutting spending, reducing debt, transferring wealth, and printing money (See Ray Dalio video for more information on this).

Generally speaking, companies and people behave no differently than the macro economy. Just think about it in human terms for a moment – if you are out of work, living off of unemployment, and have $50K in credit card debt, the first thing you should do is to cut spending, reduce debt (you can pay off your credit cards by getting a loan with a better interest rate), and ask your family for help (transferring wealth). Of course, if individuals were able to print money I’m sure you would be doing that too.

Now think about what some other people might do in this situation.

You likely can easily recognize who will get back on his or her feet and who will not. How? Well, how much experience and education do they have? How much support do they have from their families? Have you checked to see if the debt they have is a good debt (mortgage, educational loans) or a bad debt (credit cards, personal loans)?

How big and powerful is their professional network? Do they have collateral that they can sell and keep them afloat for longer? If you think about an individual on these terms, it will be easy for you to identify who is the Apple and who is the Palm in this analogy right? This same type of analysis that works on the human level, works just as well when applied to the corporate and macro levels.

Needless to say, while turnarounds don’t happen overnight and the road is far from smooth, only certain companies have what it takes to make it to the other side.

The recent stock price increase that J.C. Penney enjoyed in February can easily be reversed in March or at any other point this year. I’m not concern about that though because I’m not looking at the short term.

I know that for J.C.Penney, the turnaround process may take a few years, perhaps even five or more. I also believe J.C. Penney is one of the companies that can pull it off, and my portfolio has the potential to be greatly rewarded. Stay tuned.

Now a quick look at my portfolio: The return of the S&P 500 Index (SPX) in February 2014 was 4.4%, as compared with 4% for my Dividend Paying Large Caps portfolio.

I bought Pfizer (PFE) in February because I think Pfizer is a company that is committed to their investors through an aggressive stock repurchasing program. With the Pfizer acquisition, I completed 12 positions in my portfolio, which was my original goal for 2014.

DISCLAIMER: The investments discussed are held in client accounts as of February 28, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable. Past performance is no guarantee of future results.

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