How to Find Stocks the Market Is Mispricing

During their recent episode, Taylor, Carlisle, and Matt Sweeney discussed How to Find Stocks the Market Is Mispricing. Here’s an excerpt from the episode:

[Matt] Yeah, well, every situation is unique, of course. And, you know, the biggest pile is the too hard pile, right? So you could start looking at something and say, I think I understand what this is.

And I just went through a couple of examples there, whether, you know, whether like an optical problem could be a business that is operating well, but the CEO steps down unexpectedly, right? There are certain market participants that will see that headline and just hit the exit button right away. And maybe that’s the right call.

You know, it might be it might be the CEO is absolutely the key to the future of this business, and especially with the very small companies that could be the case. As you get a little bit, you know, bigger companies, that’s less of the less likely to be the issue. But if you see something like that, where maybe the company is doing everything right, sales are growing, margins look good, etc, etc.

But then the CEO steps down. It’s worth investigating. Why did he step down?

Is it because he’s trying to get out before the before the wave crashes and sinks the ship? Or is it because, I don’t know, his, you know, he died young, and he’s feeling nervous about that or something? There’s any number of reasons that it’s worth looking at.

So that’s like an optical problem. A structural problem is more like what I think of as my favourite investment archetype, which is really what I call good co, bad co. And you think of one stock, you know, one overarching business that has two segments or two business lines.

And one of those businesses maybe earns a dollar a share, and the other one maybe loses 50 cents a share. So on a net basis, they earn 50 cents a share. And then the market in all of its wisdom, puts a multiple on that 50 cents a share earnings.

But in the real world, that one business line is doing a dollar a share in earnings, and these worth some multiple of the dollar a share and the quants, I’m sure some quants can, you know, figure this out. But the average screener just, you know, running a dumb screener is not going to pick up on that. So then the analysis becomes what has to happen for that dollar a share to become visible to the market as the true earnings power of the combined entity.

And in the best case, you have maybe a CEO or board of directors or something like that, they own a lot of stock. And you can very, very rationally ask yourself, are these people going to continue to light money on fire forever when it’s their own money? And in almost all cases, the answer is no.

So if they simply kill off this money losing business within a reasonable amount of time, earnings power as seen by the outside world effectively doubles, you know, there’s exit costs and stuff like that. So it’s not as smooth as that. But the reality is that the earnings power of the business doubles in a reasonable period of time, it’s very hard for the stock to not go up, as long as you’re not overpaying going in.

The other outcome, of course, is maybe they’re they have this other business that they’re losing money on currently, but they believe in the longer term prospects of that business. And if that business succeeds, that’s even better, right? So then you not only erase the 50 cent loser, but you add, you know, just making up numbers, maybe you add another 25 cents of earnings power.

So then you have outside earnings power going from 50 cents a share to $1.25 a share. And, you know, it’s, it would be extremely unusual if a stock that meets those characteristics did not go up. So the real idea is just finding these things that, you know, the market maybe looks at and focusses on thinking that they’re the, you know, the truth, if you will, truth in quotes, but the truth is different than what you see in the headlines or in the numbers.