No matter whether experienced or not, almost every investor is on the hunt for undervalued stocks to make money. What could be less welcome than a stock which has fallen in price and become cheaper? The problem is, “cheap” is not automatically “cheap”. In fact, buying cheap can become a costly mistake. I see a strict urgency to clean up with this dangerous myth that a stock only has to fall enough to become attractive.

Summary and key takeaways from today’s Weekly
– Even though it might be tempting, catching fallen angels is not an easy task.
– Most stocks fall for a reason. If you do not look under the hood, better don’t try, because the risk of costly disappointments is too high.
– I also discuss the case of Bayer.

There are many pretend rules and wisdoms out there when it comes to investing.

In the recent past, I have for example written about the danger of relying on the “Lindy” effect (see here). In a nutshell, the Lindy effect claims that the longer the history of a company is, the higher the likelihood of its further survival, because it is said to have proven its resilience throughout the business cycle and different crises.

Besides the fact that I do not want to just bet on the survival of a company and its stock, I presented in my Weekly arguments that this is even complete nonsense. Wo wants to invest only based on the past without assessing the present and future? Isn’t it commonly known that the stock market is pricing in the future, not the past?

Anyway, another topic I deem necessary to put on the table is the one of “fallen angels”. These are once famous stocks that have dropped and fallen out of favor.

There’s the saying that “a stock that was attractive at higher prices, is even more attractive at lower prices, so buy more”. While true, it is also a given that stocks typically (but not always) fall for a reason. What is often not said in the same context, however, is that many people buy expensive stocks “because I think they will go up” or shares of unprofitable businesses “because they are investing for the future”.

The risk of grabbing a value trap, i.e. a stock which seems cheap and attractive, but never bounces back or at least not as initially thought, is real.

You see where I am pointing at again: it’s about risks and their management.

Even though many investors, amateurs and professionals alike, claim that there are no bad stocks, only bad prices (i.e. every stock becomes attractive at a certain price), I disagree with this philosophy.

I am a risk focussed investor who cares about business fundamentals.

In the case where a company has no future and / or is highly indebted, effectively facing bankruptcy, I see no hurry to gobble up shares of such a desperate case. Why should I place a bet where the odds are not in my favor with the risk of being wiped out entirely as a shareholder?

Even if it does not come that far: Do I want to own stocks which are not among my best, high-conviction ideas, but instead bad compromises, creating headaches? My longer term readers know that I do not like complexity as well as having to cope with problematic cases that don’t develop as initially thought.

If you’re wrong, admit it, stand to it and draw the necessary consequences.

Believe me, it is better to take a loss and have a free mind again than to hope for a comeback which may never happen. Your goal as an investor is not to bounce back to zero from a loss, but to limit your losses, while picking and holding the winners.

Ironically, my next stock idea, which I’ll publish exclusively for my Premium PLUS Members next Saturday 02 December 2023, at first sight “checks” both boxes.

It is a more than a century year old company (Lindy) and its stock price has come down by more than 40% from its all-time high (which was even in the first half of this year)! Why do I think that this is not a fallen angel that won’t come back?

Of course it has a sound business with strong economics. Double-digit margins (with a strategic shift, management has the potential to up them more), strong free cash flow generation and a storm-resistant balance sheet are the cornerstones. Add an expected enterprise value to free cash flow (EV / FCF) valuation of 9–10x and you’re almost there. As a bonus, this company is a takeover candidate for its bigger peers.

Put on your weatherproof gear and explore the details in my latest research report!

Below, you can see why it pays to focus on the winners.

The average total return of my best active stock ideas is +15.2%, easily beating the S&P500 and the iShares MSCI World ETF.

^{as per 29 November 2023 market close}

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Most stocks fall for a reason – but how to find the gems?

Over the years since I am investing in stocks (since 2011), I developed and optimized my own investment strategy as well as my research and filter process.

I pivoted away from trying to find stocks with the most upside potential towards strictly avoiding those with the highest and most obvious risks, i.e. searching for the lowest downside risks.

And yes, even though the pretend upside might be tempting and despite many other people being optimistic, I do not want to engage in 50/50 bets or worse. I’m looking for the 80/20 or 90/10 things, which admittedly are rare – but they are there!

In general, you should be rather cautious when too many people are optimistic.

Not only in the case of well running stocks like the MAG7, but also when it is about falling stocks where with time people try to find more and more excuses to not admit a mistake arguments for a coming turnaround.

There’s a saying which I believe in: “take care of the downside and the upside will take care of itself”.

While there are people, especially from the ETF crowd, who claim that this is marketing bla bla and one and the same – believe me, it is not. Especially not for your mindset as a stock picker.

I am writing this as a practitioner myself, not as someone who is afraid to buy individual stocks, because “they could fall”.

Strangely, these ETF-gurus are not afraid that their positions could fall, too (don’t indexes fall?) or that in the case of a sector rotation, historically indexes can go sideways for 10–20 years when there are exaggerations and a massive overweight of just a few stocks. Big Tech today, anyone? Financials and commodities in 2006–2007? Telecom and media in 1999–2000?

I claim that having an ETF where after 10 years nothing has happened performance-wise, the nerves will be strained.

My observation is that too many people think that what happened over the last ten years – or more precisely until the end of 2021 – will continue this way.

It is even not enough to go back until 2000, because interest rates, demographics, cheap labor and other factors have been tailwinds for 40 years in the big picture. Most of them, if not all, are now headwinds – many do not understand this. They just assume that central banks will lower interest rates again and the party will resume.

But what if not?

As a reminder, here’s a snapshot from my webinar presentation, where I discussed the topic of sector rotations:

Of course, this approach does not guarantee you an easy sailing through the markets.

Also, better do not expect to suddenly have a 100% hit rate. But my philosophy tremendously reduces the amount of loser positions and almost eliminates the hopeless cases with huge drawdowns. Keep in mind that a 33% loss needs a 50% gain, just to come back to zero. A 50% loss needs already a double.

Let’s better avoid this hard and unnerving work.

“Winning by not losing” is the better and more conservative approach than reaching for a home-run which in most cases does not materialize anyhow while accepting several big losses that have the potential to frustrate you.

How many people do you know who bought stocks of Apple (ISIN: US0378331005, Ticker: AAPL), Tesla (ISIN: US88160R1014, Ticker: TSLA) and Netflix (ISIN: US64110L1061, Ticker: NFLX) 15 years ago, held them continuously and at best even all of them simultaneously?

Or even later during their strong drawdowns?

What if there were a few Blockbuster’s, Nokia‘s (ISIN: FI0009000681, Ticker: NOKIA), IBM‘s (ISIN: US4592001014, Ticker: IBM) or other blank bullets along the way where the stock did not come back?

Sure, there’ll be an ugly duckling from time to time, nonetheless.

I can even report directly from my member’s area. For over a year, I had the stock of Flow Traders (ISIN: BMG3602E1084, Ticker: FLOW) as an active stock idea and as a free thank you bonus for everyone who subscribed to my free newsletter (updates and the closing were exclusive for my members).

Flow Traders serves as a good lessons learned case.

Even though my basic belief that operationally Flow Traders will experience tremendous tailwinds in the case of market turmoil, as was the case during 2020, due to then exploding trading activity as well as volatility and bid / ask spreads (lifting their sales and bottom line), it became an example of a nerve-draining position.

Don’t get me wrong, I was not afraid to admit that this was not a good pick.

But I waited for too long, seeking operational improvements. Instead, some things have changed for the worse, namely that I am a skeptic of all this crypto stuff. It is intransparent. This is a playing field where FLOW increased their activity. Then, there were several high-profile management departures of long-serving names which left a bitter aftertaste.

Long story short and counting dividends, I decided to close this case at a total return loss of 10% and to move on. I don’t know whether you’d believe me, but I haven’t thought about this case since then which is now exactly two months ago.

My mind was free and nothing has happened since in this regard.

Taking this haircut was the right decision. I have no trust and high conviction in this case anymore. It can remain a value trap or even worse start to develop in the negative direction. Who knows. I lack the clear upside and see risks due to lackluster markets negatively affecting their results. Plus the two points from above.

Let’s have a look at a frequently discussed stock on Twitter / X where I have NOT issued a research report for my members for a good reason or two, but it serves as a prime example to stress my point that no matter how much the stock falls, the risks are simply too big to be ignored.

Fallen Angel + Value Trap: Bayer (ISIN: DE000BAY0017, Ticker: BAYN)

I have been writing on Twitter / X for long that this is a value trap and I already had negative feelings about it after the Monsanto acquisition in 2016. It was a toxic stock for me, completely uninvestable.

This is a perfect example of first the infamous “stupid German money” from the side of Bayer’s management and later of desperate stockholders applying buy and hold and pray, believing in (or desperately hoping for?) a turnaround.

More hopium does not lift the stock, though.

The company is rotten from within and the bite they made with acquiring Monsanto was too big for them. Although it was clear that even in the best case digesting it would take time as Bayer took a huge debt load on its balance sheet, there is more to this case than just penalties for Glyphosat / Roundup which indeed is just the tip of the iceberg.

Those who claim the above have no clue what they’re talking about.

Bayer is barely growing. Plus, they have problems to generate sufficient cash flow. I have a different understanding of creating synergies after acquisitions and generating shareholder value, as they claim on their investor relations website.

The huge debt load cannot be paid back and refinancing at now dramatically higher cost of debt increases interest expenses, thus negatively affecting the bottom line. Free cash flow was negative so far this year and in the short term, 12 bn. EUR of financial debt will mature. Bayer has less than 7 bn. EUR of cash.

While refinancing is not the problem or a bad thing per se, there will come a time when creditors could and likely will demand more safety as they won’t be watching debt to grow perpetually.

Bayer already took on more debt this year, because operations did not generate a positive cash flow. Now, net debt is even higher (38 bn. EUR, not in the chart below) than it was at the time of the poisonous acquisition (36 bn. EUR).

It is by no means just this agriscience division that has hit Bayer in the face.

Add to all of this the approaching loss of exclusivity of two of their blockbuster drugs from the Pharma unit and you’ll see that the quality is very low. The two most important drugs and sales generators are the blood thinner Xarelto and the eyecare drug Eylea. Together, they account for about 40% of sales within the Pharma unit (which in itself generates 40% of Bayer’s total revenue).

Unfortunately, exactly those two are losing their exclusivity (LOE or patent protection) during 2024 and 2025.

If you look closer, you’ll also see that forth-placed “Jivi” will also lose its protection in 2025 in Germany, China, Brazil, the UK and the USA.

But sales are not everything.

Let’s have a look at Bayer’s operating results and also the results these two divisions achieved (I am leaving the third division, off-patent drugs or just “Healthcare” aside).

Bayer generated cash flow from operating actives and also EBIT of 7 bn. EUR each and free cash flow acording to their numbers of 3.1 bn. EUR (TIKR says 4.1 bn. EUR) for the whole company.

I hope you’re not surprised to see that Pharma (the division where LOE’s are coming) contributed 71% of total EBIT, 50% of operating cash flows and 81% to FCF (in relation to Bayer’s number of 3.1 bn. EUR).

Who shall buy either the agriscience division with its huge risks and litigations or Pharma with its breaking-away sales and cash flows? And: at what price?

Spin-offs don’t solve the debt problem, as they do not bring in urgently needed cash.

By the way, the third often discussed option, a divesture of the Healthcare (off-patent) business is now also almost off the table:

The negotiating position is weak, debt is high and growing. Why the heck shall anyone invest here? I expect a capital raise soon (possibly diluting shareholders by 10–15%, I do not even rule out 20% if management is courageous and serious with the issues), which will not even solve the problems, but at least give them some breathing room in the short term.

Just for reference: a 20% dilution would only bring 6 bn. EUR at current prices. That’s merely enough to close the gap between cash and short term financial debt (assuming no cash flow generation).

I don’t care that the PE ratio is less than 5x (on unsafe earnings assumptions) and the dividend yield robs towards 8% – which by the way should be suspended as they cannot afford to pay it.

The enterprise value, i.e. market cap plus net debt, is around 70 bn. EUR. This is still hefty. In relation to last year’s operating (not free) cash flow, this is still a multiple of 10x – not counting all the operational risks. This year so far, free cash flow was negative.

How do you want to value such a business seriously?

What am I doing to circumvent and ignore such cases when searching for new stock ideas? In a nutshell, the things I am looking at are:

• the development of sales, operating earnings and cash flows
• free cash flow generation
• margins and margin trends
• the debt situation as well as interest rate sensitivity
• valuation – on serious metrics, not adjusted EBITDA figures or pretend future market potential or the likes

If all the above are clean, chances are way higher for a successful pick.

What comes on top, I do not want to have too complex cases and no big risks from the side of operations or even litigations that could destroy the company, like in the case of Bayer.

I see such a case in my latest idea for my Premium PLUS members.

Conclusion

Even though it might be tempting, catching fallen angels is not an easy task.

Most stocks fall for a reason. If you do not look under the hood, better don’t try, because the risk of costly disappointments is too high.

I also discuss the case of Bayer.

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