street sense
Finding Balance Sheet Bargains
When a company's stock price falls below its cash assets, it usually means the stock is undervalued.

In October, the price of Millenium Pharmaceuticals' stock fell below $7 a share, causing many investors who look at balance sheets to sit up and take notice. The reason for their interest? Millenium, a promising biotech company with a strong pipeline of developmental-stage drugs, had cash holdings of just about $7 a share on its books.

Savvy investors recognized that if they could buy Millenium shares for the price of its cash assets, they were literally getting the drug pipeline and the rest of the company's noncash assets for free. So they stepped in and bought Millenium shares, and within a month the stock was back over $10.

In this month's column, I'll explain why being able to read a company's balance sheet is one of the best guides to finding bargains in the stock market.

To understand how the stock of a formerly high-flying biotech company can reach a point at which the shares are trading at cash value, one must recognize that all long-term market downturns end with a period of indiscriminate selling. We saw similar examples of gross undervaluation at the tail end of the 1973-74 and 1981-82 bear markets.

There are usually two types of companies whose share price can sink to the value of the company's cash assets:

Old-line industrial companies. On occasion, low-tech industrial companies with weak prospects for growth will eventually see their stock prices shrink to finally reach the level of their cash holdings. This usually occurs through a process of slow erosion, as investors find little reason to justify holding on to such unpromising stocks through a long bear market. When the stock prices of such companies reach a truly undervalued level, they usually get taken over by larger firms in the same industry.

This kind of industry consolidation makes sense. As an investor, I may not want to own stock in a stodgy company that makes valves, but a bigger valve company is likely to see advantages is acquiring a smaller competitor's product line and technology at a cheap price.

Developmental high-tech companies. Firms pursuing the development of advanced technologies and concepts are also likely to trade near their cash value toward the end of a long bear market. These are companies like the aforementioned Millenium Pharmaceuticals, which have raised a lot of cash to conduct research but have yet to turn a profit.

These companies can become tremendously undervalued in bear markets because already-pessimistic investors eventually begin to believe that the cash will be used up in conducting expensive research that never leads to marketable products.

In reality, many developmental-stage companies do "burn" through all their cash and become bankrupt, or at best cheap acquisition targets. However, investors who have the intelligence to accurately evaluate developmental-stage companies and the patience to wait for their products to come to market can reap some of the biggest payoffs that the stock market offers.

History Can Repeat

Though it may seem like ancient history now, we should remember that Xerox, IBM, Microsoft, Cisco Systems and many of today's corporate giants began as developmental-stage technology companies. It stands to reason that at least some of the tech or biotech stocks trading at mere cash value in recent months will become the hot new growth stocks of the next bull market.

Do Your Homework

No one can identify all the companies that will be winners in the next up cycle, but the combination of promising technology and a stock price that barely reflects a company's cash assets should be enough to at least pique a sharp investor's interest. Doing your homework could prove quite profitable.

Ophthalmology Management Associate Editor Jerry Helzner has written more than 50 articles on stock investing for Barron's. He has been a regular stock market columnist for other business publications and was a member of the equity research department of a major regional brokerage firm.