Wisdom on Value Investing: How to Profit on Fallen Angels

Q&A with Author Gabriel Wisdom

Q: What traits make up a good investor?

A: It’s important to recognize that the traits of top investors run counter to the instincts of most, if not all, human beings.  First of all, and most importantly, they buy when everyone is complaining, and sell when they are celebrating. Knowing when to buy and well to sell is crucial when investing. Therefore they always have a methodology to weigh the value of their holdings and they stick to it when times are tough.  Of course, they have an exit strategy and they recognize that volatility is not the same as risk. Their portfolios are diversified, but never overly diversified and they learn from their mistakes. They understand risk and pre-program themselves to take advantage of an opportunity quickly.

Q: In regards to deciding what stocks to buy, what do you recommend as a checklist for successful investing?

A: I have my own Pilot’s Checklist for Successful Investing.  As a private pilot myself, it is important to do a thorough check of your aircraft before liftoff—the same goes for investing.  It’s a three part process.  First, there are the quality checks on the return on equity, profitability, debt, cash flow, and revenue and earnings growth.  Part two involves valuation checks on earnings yield, free cash flow yield, P/E ration, price-to-sales ratio, and price-to-earnings ratio divided by growth rate (PE/G).  Finally, time checks need to be done using moving averages, short interest, and insider buying and selling. It sounds overwhelming, but my book breaks it all down as well as providing easy-to-follow explanations and examples for the beginner and even inexperienced investor.

Q: What would you say a “healthy” properly diversified portfolio looks like?

A: Generally a portfolio composed of 20 to 30 stocks should provide for adequate diversification, with no single stock representing more than 4 percent of your total portfolio value. In addition to stock diversification, you should consider sector diversification. A good rule of thumb is not to invest more than 20 percent of your portfolio in any one sector. Sectors tend to move in cycles, so having exposure to several sectors should help smooth out your returns over time. The 10 S&P sectors are Telecom Services, Utilities, Consumer Discretionary, Consumer Staples, Energy, Financials, Health Care, Industrials, Information Technology, and Materials.  For broader diversification, Exchange Traded Funds (ETF) are a good choice.

Q: What is a Fallen Angel and how does it fit into your investment strategy?

A: The term originated on Wall Street many years ago, and it describes a stock or bond that has fallen but should rise again. Not all depressed investments are Fallen Angels; in fact, most of them are not. Recognizing the difference between the fallen and the falling is vitally important. I present various methods for screening the multitude of domestic and international companies to find hidden gems in the book, but some general rules include finding companies in which shareholders’ equity is growing at or above 15 percent and revenue and earnings are at or above 10 percent a year regardless of share price. The key is to locate these companies ahead of time and wait patiently for them to go on sale.

Q: If Fallen Angels represent such great companies, why isn’t their stock price always in relation to their value.

A: Some of the factors that create Fallen Angels come under the control of the company themselves, and others don’t. The first force that creates Fallen Angels is the business cycle, which lasts an average of four years. Different industry sectors will expand or extract depending on where we are in the economic cycle. A one-time calamity befalling an otherwise solid, successful company is another factor. A market crash or widespread panic, like those we’ve experienced recently, creates Fallen Angels. Panic is the overriding instinct that causes otherwise solid stocks and bonds to suddenly go on sale.

Q: Besides Fallen Angels, are there other opportunities for investors?

A: Certainly, investors should look for out-of-favor blue chip stocks, brand names and well-known franchises that have encountered a temporary setback. Spinoffs are good because they often trade under the radar of Wall Street and the general public, keeping their stock price down for a time. Thousands of publicly traded small caps are cheap because no one is paying much attention to them. Look for small caps with products and services that are catching on with consumers. Follow capital allocators, like Warren Buffet’s Berkshire Hathaway, to seek what they are put their money into. Proven allocators of capital put their company’s money to work in the most profitable ventures they can sniff out. Other opportunities include distressed companies that find themselves in an industry-wide funk, companies that have emerged from bankruptcy, and companies that are being targeted by high-profile activist shareholders.

Q: How do you know when to sell?

A: The first thing to remember is that no one buys at the bottom or sells at the top.  The best thing is to get within the range. If profits occur faster than anticipated, it is time to sell. Rapid success can make you far too optimistic about the future. Like the gambler who hits a jackpot in Las Vegas, you think you are on a roll. If the crowd is competing to buy your shares at almost any price, it’s your job to sell to them. On the opposite side, sell an investment when the reason that you bought it is no longer valid. For example, you purchased shares in the company because it appeared to be cheap, the company was growing and its share price was depressed, but new information becomes available, the company restates earnings or an accounting scandal starts to unfold. Rather than stay in denial and wait for things to turn around, it’s time to sell. Psychologists say it’s tough for investors to sell at a loss, because the pain of losses is twice as great as the enjoyment of gains, but there is an old Wall Street saying that your first loss is your smallest. My advice is if you are ever unsure, sell at least half of your position.