Mutual Funds: Bad Time Bargains

A company with great prospects hits hard times, a top executive winds up in court and the stock starts to tank. That's when smart investors run, right?

Maybe, maybe not. If you're a mutual fund manager with an eye for what Wall Street calls "deep value," you might spot a buying opportunity where others only see negative headlines. It may seem counterintuitive to the average investor, but sometimes bad publicity can be a good thing.

The key, money managers say, is to thoroughly evaluate a company's balance sheet, decide whether the situation can be resolved in a year or two and keep a long-term perspective.

"It's fairly common for value investors to kind of embrace a troubled company," said Kunal Kapoor, director of mutual fund research at Morningstar Inc. "This is often when a stock can be bought for a song."

Stocking Up on Tyco

That's what Putnam New Value fund manager David L. King was thinking when he continued to buy shares of Tyco International after its top officers were charged with looting more than $600 million from the company.

Tyco, a massive conglomerate that makes everything from coat hangers and trash bags to sophisticated medical devices, was trading in the low $40s when King started buying it, and he kept buying it as the share price sank — an investing strategy known as "averaging down." Using this tactic, King wound up paying an average of $16 a share over several years. Now that the stock is trading near $29 and he's collected 1.7 million shares, King reckons he's booked about $21 million in profits.

"When something you buy all the time goes on sale at the store, you buy a little extra and you put it in the closet," King said. "Why would you do it differently when you're buying stock?"

King wasn't the only manager shopping for Tyco when it was being shunned by the rest of the market. Bill Miller, manager of the highly regarded Legg Mason Value Trust, liked it so much it has become his third-largest holding. Other funds that take this sort of approach include Clipper, Longleaf Partners and Third Avenue Value.

Deep value investing can bring great rewards, but it can also pose greater-than-average risks. For a more aggressive investor with a growth-intensive portfolio, a fund with a deep value bent can be a stabilizing influence. But a more conservative investor wouldn't want to make it a core holding.

"If you're going to buy one of these funds, understand that there is an opportunity for short-term volatility," Kapoor said. "Don't assume just because it's a value fund it's risk free."

Be Patient

Potential buying opportunities come with varying degrees of risk as well, said John Buckingham, manager of the small-cap Al Frank fund.

An opportunity can be a major event in a company's history, such as Martha Stewart's conviction for lying to prosecutors about a stock trade, or something less dramatic, like an earnings report that missed Wall Street's estimates or the unexpected resignation of a senior executive. The important thing from an investing standpoint is the degree of damage, and whether it pushes the price of a desirable stock to an appealing level.

In the case of Martha Stewart Omnimedia, the domestic goods empire Stewart built from scratch, there's little to draw value managers. Most say the stock is still too expensive at $10 per share, and it's not clear whether the company can successfully distance itself from its convicted founder. Buckingham said he wouldn't consider buying Omnimedia until it falls to the $6 range.

Waiting for a stock to get to a fair value, holding it through difficult times and then waiting for it to rise before pocketing the gains, takes some patience, Buckingham said. "And that's a thing most investors don't have." Most value investors don't intentionally seek out troubled stocks, they look for good investments that are selling for less than they're worth. What makes deep value investors different is that they're less likely to turn away when a scandal is driving the discount.

That's how King, who only invests in large, established companies, wound up with stocks like home lenders Fannie Mae and Freddie Mac, which are facing scrutiny over their accounting practices; drugstore chain Rite Aid, which was accused of misrepresenting its financial results; and Xerox Corp., which struggled through a downturn and now has better prospects.

All these companies are generally industry leaders, with significant revenues, many employees and a number of constituencies depending on their survival. That makes them less vulnerable to short-term problems, and more likely to be successful over time.

"A long-term view and investment discipline is much more important than being a genius when it comes to this kind of investing," King said. "The best ideas, in retrospect, always look so simple. They don't come from complex, precise predictions about the future."