On a Possible Cause for JRN’s Undervaluation
I thought a discussion of the possible causes of Journal Communications’ undervaluation by the market might help us find other similarly undervalued stocks. In the Gannon on Investing Podcast: “Why Small Caps” I stated that undervalued stocks usually suffer from either contempt or neglect. JRN suffers from both.
Journal Communications (JRN) is a relatively small company, despite the diversity of its media assets. The company owns a collection of low profile media assets. The same size company with a well known flagship would not go as unnoticed by investors. Although the Journal Sentinel is a big paper, I don’t believe most investors know the name. Of course, most daily newspapers are only known in and around the city in which they are published. That brings up another possible cause of JRN’s undervaluation. Perhaps the location of the company’s assets has helped it fly under the investing public’s radar.
Maybe. But, I’m not so sure. All of those factors could contribute to the lack of interest in JRN. However, I doubt they are the primary cause.
One of the best possible explanations for JRN’s undervaluation is the company’s lack of debt. Journal Communications is not debt free; however, for a media company, it is very lightly encumbered. Actually, the company also has a low debt load relative to the S&P; 500. But, I want to focus on the company’s debt relative to other media companies, particularly other newspaper publishers, because I believe that is a key cause of the undervaluation.
The stock market doesn’t totally ignore debt. However, it sometimes fails to fully account for the differences in debt levels between companies. In general, unduly leveraged companies are punished by the market. All other things being equal, the stock of such companies trades at a lower P/E ratio. In this way, the stock market does account for debt.
However, punishing companies with a lot of debt is not quite the same thing as rewarding companies with very little debt. That’s where mispricings can occur. Some businesses in exceptional financial condition are not awarded the premiums they deserve. Such businesses are better able to make acquisitions, buy back stock, increase dividend payments, and weather tough times. Just as importantly, they also have the capacity to take on more debt.
On occasion, I have read the argument that excess cash on the balance sheet may be a bad sign, because it suggests management is not running the business in the way that would best maximize returns on equity. It is true that some companies have more cash and less debt than would be best for the maximization of shareholder returns. However, from this, it does not necessarily follow that such companies are less desirable investments.
I have touched on enterprise value a few times before. There is a reason for this. A business’ enterprise value is a better measure of price than its market capitalization. Generally speaking, a company’s cash can be treated as a reduction to the price paid for the operating business, and a company’s debt can be treated as an increase in the price paid for the operating business. Now, some people have argued, quite correctly, that the debt itself does not really increase the purchase price for the buyer of the common stock.
After all, a company could continually refinance its debt. It is even possible for a company to pay out a hefty dividend despite a fair amount of debt. An investor does not really intend to hold a company’s stock forever. Therefore, he needn’t worry about debt levels that do not rise to alarming heights. Obviously, he must consider the matter of interest payments. But, the debt itself is not his concern.
I don’t particularly care for this argument. The world is an uncertain place. An investor can not be sure a company’s debt will be refinanced on equally favorable terms in the future. At least as importantly, an investor can not be sure his returns will come in the form of dividends. It is quite possible the company will be acquired. Then, the debt assumed by the acquirer will be his concern.
I believe investors will do best to always take a full and careful account of a company’s debt. This does not necessarily mean that they must always use enterprise values in their analyses. It simply means they can not ignore a company’s debt. An investor who evaluates a company solely on metrics such as after-tax earnings, P/E ratios, and returns on equity is effectively ignoring that company’s debt.
A high return on assets coupled with a low debt/equity ratio is a surprisingly effective screen for undervalued stocks. I don’t think is merely a quality issue. I think it is also an issue of price. Businesses that earn good returns on capital while employing a lot of debt will be more conspicuous when they fall well below their intrinsic value. They will tend to have low P/E ratios and high returns on equity.
Businesses that earn good returns on capital while employing little or no debt will sometimes go unnoticed when they fall well below their intrinsic value. Their P/E ratios may be a bit higher and their returns on equity may be quite a bit lower. However, they will be, in many respects, no different from the businesses with high returns on equity and low P/E ratios. Don’t let a bargain pass unnoticed just because a company’s capital structure doesn’t perfectly adhere to the norm.
After all, it’s often best to fish where others aren’t.
Happy Hunting