Absolutely scandalous: Why bad news makes for good investments

If you want to make money in stocks, just ignore every article you read about them (except this one, of course). Or so the message might seem if you follow the advice of great value investors. They seek to exploit the perception gap between how they and the media view the world — the so-called headline risk — to profit by buying what everyone else is selling. In other words, they like scandal stocks.

Take the case of natural gas driller Chesapeake Energy Corp. Aside from the enormous damage plummeting natural gas prices have caused the company, its shares were clobbered this April as news broke that it was under investigation by the Securities and Exchange Commission because Chief Executive Officer Aubrey McClendon had borrowed more than $1 billion from the company to finance private stakes in wells that Chesapeake drilled, a serious conflict of interest.

The Long View
Chesapeake shares have fallen about 33 percent during the past 12 months and are down 8.7 percent so far this year. Yet value-oriented manager Staley Cates of the highly regarded Longleaf Partners Fund has defended his position in the company, which was the largest holding in the $8.1 billion fund as of June 30, at 7.2 percent of assets. At a shareholder meeting in May he stated, “Chesapeake’s natural gas assets are arguably the best in this world. Currently, the price of natural gas is so low … that having the best assets in the world doesn’t mean a lot to Mr. Market. But long-term, this position is compelling.”

Most value investors tend to be buy-and-hold investors like Cates. “One of the best ways to make money is to have the ability to look past a bad headline,” says Stephen Dodson, manager of the Bretton Fund. “If you have the time horizon to be able to do that, it’s one of the greatest advantages you can have. The questions I think through after each negative headline are: Is there something fundamental that permanently impairs the future earnings ability? Or is this just a short-term hit?”

Opportunistic Buys
Dodson has outperformed 99 percent of his peers in the mid-cap blend fund category in the past year. His fund has a 36 percent return, thanks to a concentrated portfolio of 16 stocks — some of which, such as JPMorgan Chase & Co., have had significant headline risk. Morgan admitted on May 10 that a trader nicknamed “the London Whale” lost it $2 billion. The stock fell 10 percent to $36.65 the day after the initial announcement. Then, as the full extent of the damage became clear — some $5.8 billion in losses — shares dropped another 16 percent to a 2012 low of $30.74 by June 15. Dodson was buying more during this time. “I came to the conclusion that this was a one-time loss that wasn’t going to damage JPMorgan’s business,” he says. “It was not something that will cause less people to give it their deposits or affect its ability to generate fee income or make loans. The drop in the stock’s market value because of the news was way larger than the loss to the company’s current earnings.”

Every investor has a different definition of what sort of headlines make them nervous. For Dodson it’s accounting irregularities, the sort that might lead to the next Enron. Some managers argue even accounting issues can be temporary hiccups or honest mistakes. “It’s difficult to assess accounting issues, but if a company has a reasonably strong balance sheet, you can take a chance on it,” says James Potkul, manager of the Bread & Butter Fund, which has beaten 90 percent of peers during the last five years in the large-cap value category. “A good example is [garbage disposal and recycling company] Waste Management. It had an accounting issue years ago, but we knew it was a solid steady business with a reasonably good balance sheet,” Potkul says. “So we bought into it and have held it profitably in our separate accounts for many years.”

By contrast, Potkul found the behavior of McClendon at Chesapeake too egregious and sold out of his 3 percent position. “I always understood there was a corporate governance issue, but I didn’t understand the extent until the latest news,” he says. The sin also became unforgivable because of the nature of Chesapeake’s business and its overleveraged balance sheet. “Waste Management has a more stable business in an industry it dominates compared to Chesapeake, which is in the unstable natural gas exploration business and has a massive amount of debt,” Potkul says.

Hedging Headline Risk
If you think a company’s stock is cheap but are leery of the headline risk, a compromise is to buy its bonds or preferred stock. Because such investments are senior in the capital structure to common stock, they get first priority during any potential bankruptcy so capital can be preserved on the downside. “We bought the bonds of Chesapeake Energy after the news about McClendon broke,” says Ted Crawford, co-manager of the Roumell Opportunistic Value Fund. “The bonds came down in value to where we can get a 7.5 percent yield for five to six years, and they’re a better quality than typical high-yield bonds because of the value of the natural gas assets the company has in the ground.”

One thing’s certain: Buying stocks exposed to headline risk exposes you to more volatility as the negative press plays out. As such, value funds tend to be more volatile and are not suitable for short-term investors. Longleaf Partners has been 35 percent more volatile than the Standard & Poor’s 500 stock-index during the last five years and lagged 89 percent of peers in Morningstar’s large-cap blend fund category. In the last 15 years, however, the 165 percent cumulative total return that longtime manager Cates has achieved is more than double the 74.5 percent of its average peer and beats the S&P 500’s 104.7 percent by a wide margin. So maybe you should stop reading this article and start thinking long-term instead.

–Bloomberg News–