Call us morons

Benj Gallander and Ben Stadelmann
Friday, December 20, 2002

Our annual December ritual of buying beat-up stocks is in progress, and readers may find it interesting to examine the process that winnows our short list to the final candidates. This methodology is outlined in Benj’s new book The Contrarian Investor’s 13 and is akin to how banks score customers’ credit worthiness — with points awarded or deducted for specific criteria. One company that was recently culled in this manner is Xerox, a name that has been hanging around our Watch List for a couple of years.

Xerox has been trying to turn around for so long that many have forgotten it was once the epitome of the glamour tech stock — the Cisco Systems of the 1960s’ elite Nifty Fifty.

In its heyday in 1971, Xerox gathered an array of scientific brainpower to create the Palo Alto Research Center, perhaps the greatest crucible of invention since Edison’s time. The stream of new technologies created defined the computer age as we know it: the laser printer, distributed processing, networked PCs, the graphical user interface, object oriented programming, Ethernet … all this before disco!

However, Xerox failed to realize the value of its discoveries and instead struck out in such new directions as insurance and financial services — with disastrous results. The year 1994 was a time of reinvention, as the copier company recast itself as “The Document Company.”

At first, this seemed to work well, and shares rose steadily from $15 to more than $60 in 1999. But the reality of the nasty squeeze between cheaper copiers from Japanese rivals, and Hewlett-Packard’s ubiquitous ink-jet printers eventually crystallized for investors, and the shares nosedived to $5 — and onto the Contra Guys’ Watch List.

Since then, the bottoming process has kept the stock in the $6-to-$10 range. That’s important, as we subtract a point in our evaluation for stocks with a recent downward price spiral. The upside from here is very attractive: while a return to $60 is unlikely, a triple is plausible. That’s worth two points in this category, one for each net gain multiple by which we feel the stock price can reasonably increase. Also on the plus side, points were awarded for management ownership, recent insider buying, and strong R&D expenditures.

In the minus column, two points were deducted for an ugly balance sheet, one weighted down by $14 billion in debt. With a debt-to-equity ratio of 5.4 and a quick ratio of 1.1, there is precious little room for error, so another point was subtracted for a lack of a margin of safety.

On balance, Xerox is an attractive contrarian pick, but not a compelling one. Our guess is that Xerox isn’t quite ready to photocopy its past success.