Prospecting in Bad News: Finding Stocks in a Real Estate Crash

Book: Beating the Street by Peter Lynch with John Rothchild | ISBN: 978-0-671-75915-5

By late 1991, everyone was convinced that real estate was collapsing. For-sale signs were popping up like weeds. Fat-cat homeowners in places like Marblehead, Massachusetts, were complaining that their houses were worth 30 to 40 percent less than a couple years ago. Newspapers ran collapse stories almost daily.

Peter Lynch saw the same headlines. But he also noticed something on the back pages that nobody was talking about. The price of the median house in America was actually going up. It went up in 1989, in 1990, and again in 1991. It had gone up every single year since 1968.

The “collapse” was mostly happening in fancy commercial real estate and expensive neighborhoods. The broader housing market was fine. But since newspaper editors, TV anchors, and Wall Street money managers all lived in expensive neighborhoods, they reported their own experience as if it were everyone’s.

Lynch brought this up at the Barron’s Roundtable. Nobody believed him.

The Quiet Facts

Lynch has a technique he comes back to again and again. Wait until the prevailing opinion about an industry is that things have gone from bad to worse. Then buy shares in the strongest companies in the group.

The key is what he calls “quiet facts.” These are data points that tell a different story than the headlines. For housing in the early 1990s, the quiet facts included the rising median home price, the improving affordability index, and declining interest rates making mortgages cheaper than they’d been in a decade.

He’s careful to note this isn’t foolproof. In oil and gas, people said things couldn’t get worse in 1984, and they kept getting worse for years. You need the quiet facts to actually point toward recovery. Don’t just buy something because it’s been beaten down.

Toll Brothers: The One That Got Away

Lynch first looked at Toll Brothers, a home builder. The stock had dropped from $12 to $2. A five-bagger in reverse. But the company had reduced its debt by $28 million, increased cash by $22 million, and had a two-year backlog of orders. Its competitors were going bankrupt, which meant Toll Brothers would eventually grab a bigger share of the market.

Lynch put it at the top of his list. But before he could publish the pick, the stock quadrupled. Other bargain hunters had found it first. Lesson learned: when you find a beaten-down stock with strong fundamentals, act quickly. The market is full of other people who can read a balance sheet.

Pier 1: The Housing Play Nobody Noticed

Frustrated about missing Toll Brothers, Lynch started thinking about which companies would benefit from a housing recovery in less obvious ways. People who bought houses would need lamps, dish racks, rugs, knickknacks, and rattan furniture. Pier 1 sold all of that at affordable prices.

Pier 1 had been through two big crashes already. It dropped from $14 to $4 in 1987, bounced back to $12, then got hammered down to $3 during the Saddam Sell-off. By the time Lynch looked at it seriously, it was at $7.

The numbers were encouraging. Twelve years of record earnings before the recession hit. Expanding at 25 to 40 new stores per year. Only 500 stores total, so nowhere near market saturation. Same-store sales were down 9 percent in the hardest-hit regions but up everywhere else. In a recession, that’s actually not bad.

Lynch checked inventories, which were higher but only because of 25 new store openings. He talked to the CEO. The company was cutting costs and improving margins even while growing. Debt was being paid down. And at a p/e of 10 for a 15 percent grower, the stock was cheap.

The bonus was Sunbelt Nursery, which led Lynch on another trail entirely.

Sunbelt Nursery: One Stock Leads to Another

Lynch says one stock often leads to another. Pier 1 owned half of Sunbelt Nursery, a chain of lawn and garden centers. And if people buying houses need furniture, they also need trees, shrubs, and flowers.

Sunbelt had just gone public at $8.50 per share. After one bad quarter caused by freak weather (frost in Arizona, 14 inches of rain in Texas), the stock dropped to $5. Half its value, gone because of weather. But the company still had $2 per share in cash, zero debt, and solid renovation plans.

Lynch did a simple comparison. Calloway’s, a smaller nursery chain with just 13 stores, had a market value of $40 million. Sunbelt had 98 stores and was valued at only $31 million. Even if you assumed Sunbelt’s stores were half as valuable as Calloway’s, the company should have been worth $200 million, or more than $30 a share. It was trading at $5.

The nursery business was also one of the last mom-and-pop industries that hadn’t been taken over by chains. Sunbelt could potentially do for garden centers what Dunkin’ Donuts did for donuts.

General Host: The Calculator Test

Sunbelt led Lynch to General Host, which owned 280 Frank’s Nursery outlets. General Host’s stock was at $7, but the company had recently bought back its own shares at $10. When you can buy something for less than the company paid for it, that’s worth investigating.

Lynch did his “three-minute balance sheet drill.” Book value was $9 per share. Cash was $65 million. Goodwill was only $22.9 million out of $148 million in assets, which was acceptable. The debt was $167 million against $148 million in equity, which was concerning but mitigated by the fact that most of it was long-term and not owed to banks.

The insiders were holding, not selling. The company had concrete plans: new scanning systems, satellite inventory tracking, Christmas kiosks in malls, and new Frank’s Nursery openings targeting 430 stores by 1995.

Lynch applied his calculator test. If Calloway’s 13 stores were worth $40 million ($3 million per store), and Frank’s 280 stores were worth even half that ($1.5 million each), General Host’s nursery operations alone were worth $420 million. Subtract $167 million in debt and you get $253 million. With 17.9 million shares outstanding, that’s about $14 per share. The stock was at $7.

Bad news in an industry doesn’t mean every company in that industry is in trouble. Sometimes the strongest companies are just temporarily caught in the crossfire.

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