Qualiport

[ October 16, 2000 ]

Pitching For The Glitch

By Maynard Paton (TMFMayn)

Carburton Street, London -- Bruce wrote an excellent article last week about "glitch investing".

He stated: "Increasingly so, I am firmly of the opinion that the time to buy companies is on the glitch. Throughout a company's long corporate life, they will undoubtedly go through bad patches... The challenge for the private investor is to determine whether this is a temporary or permanent glitch -- no mean task."

I agree.

Great companies firing on all cylinders usually come with a steep share price tag. If everyone knows the upbeat story, then the investment potential will be limited. It's the old Great Company, Bad Stock situation.

But buying companies when they hit trouble can lead to investment value. It's a strategy that Warren Buffett has put to good use. Of his eight major stock picks from the last thirty years, two were bought when the company was in deep distress.

But beware! Glitch investing is by no means easy. It can be very rewarding should you get it right, an absolute disaster should you get it wrong.

Here are three points to consider when contemplating "pitching for the glitch".

Know your business

First and foremost, due consideration must be given to the type of business undergoing the glitch.

Every company can be subject to an operational turnaround. Yet a company's poor products or its poor competitive position will take plenty of management effort to sort out. The investor should only consider companies with eminently solvable problems. Particularly enticing are those companies where an attractive core business remains intact, but where the former management's actions have caused the share price to tumble. Alternatively, well-managed companies suffering from industry-wide problems (e.g. a recession) can make for appealing investments.

The mismanaged franchise type of glitch is my favourite. Find a company that has industry leading products and a great niche, but requires fresh managerial input to get the company back on track. Then wait until the new management's actions start to filter through into the accounts and buy in.

However, all that's easier said than done. Read this article and then look at this chart for an example of the real life difficulties.

"Never Catch a Falling Knife"

The second point to make revolves around a somewhat hackneyed stock market phrase. In my experience, the other well-worn adage of "profit warnings always come in threes" rings very true.

It's a rare company that succumbs to an operating glitch without the need to issue further bad news. Typically, a trading statement will give the initial disappointment, but then subsequent results will further dampen investors' expectations. Investors should always consider this "drip feeding of bad news" phenomenon before diving in immediately after the first signs of gloom.

Indeed, it will be interesting to see whether the "drip feeding of bad news" holds true for the likes of Intel (Nasdaq: INTC), Apple Computer (Nasdaq: AAPL) and Dell Computer Corporation (Nasdaq: DELL). We won't have too long to find out, as both Intel and Apple report their third quarter numbers this week. My view? I don't see any near-term recovery on the cards for the US tech giants.

After the company hits a glitch, it's always worth waiting for the next set of results to digest the impact of the earlier warning. The real skill for the glitch investor is being able to judge when the poor "newsflow" has ended. Ask anybody holding Marks & Spencer (LSE: MKS) about the difficulties this task presents.

Valuation counts

The third point for the glitch investor is valuation. Even though investors should be mindful that valuation always counts, it's even more the case with companies undergoing temporary problems. A substantial margin of safety needs to be applied, given the prospect that further bad news could just be over the horizon.

Another valuation issue is that it can be difficult to make a suitable "fair value" assessment when a company is undergoing profit problems. Depressed earnings that could turn into losses, a myriad of exceptional items or passed dividends can make the task of valuation difficult.

The company may appear expensive when it is measured against its disappointing profits, but it's how the valuation relates to the profit generated post-recovery that counts. Of course, valuation matters are further complicated by the time it will take the company to recover, assuming that it eventually does.

Glitch investing in action

The Qualiport, to some degree, has already tried its hand at glitch investing. The purchase of MMT Computing (LSE: MMT), an IT consultancy, was perhaps our first venture into this style of investment. Albeit a historically well-managed company, MMT couldn't avoid the IT industry's Y2K glitch. The story of MMT highlights some of the aforementioned dangers.

During January 1999, MMT warned that the need for its services would decrease from the exceptional levels seen in mid-1998. The news wasn't too surprising, given the IT industry's forthcoming Y2K "freeze". But MMT shares promptly fell from about 900p to 700p.

Y2K came and went and investors, including the Qualiport, looked for a revival. It wasn't to be. Like many other IT firms, MMT experienced a delayed recovery as blue-chip clients emerged from their Millennium bunkers later than expected.

So nearly two years after the initial warning and three subsequent results releases, "good news" is still to emerge from MMT. The shares, at 610p, still remain 30% below their January 1999 high. Fortunately, the Qualiport looks to have been prudent in its application of the margin of safety. In the six months since the initial purchase, we've made a small paper profit on MMT. Meanwhile, the Software and Services sector has fallen 13%.

MMT's next results, to be published next month, should herald the start of their post-Y2K turnaround. But having said that, there is the possibility that the results could further highlight the inherent dangers of glitch investing.

Where Next?

• Games Workshop -- review a "near-miss" glitch investment
• MMT under the Microscope