“True contrarians don’t sit on their hands when there is an opportunity — when fear overrides the market.”

That is what John Rogers Jr., founder of Ariel Capital, told an audience of several hundred value investors (mostly institutional) two weeks ago in Los Angeles. Of course, everyone just nodded their heads in agreement.

Any serious investor knows the only way to beat the market on a regular basis is to make investment decisions that go against the herd — that 99% of the world is too afraid to make. But few have the guts to do it.

John does. He has made a living betting against the crowd.

His flagship Ariel Fund has averaged a 13.9% return since 1986. It has handily beaten the Russell 2000 and S&P 500 over that stretch. Some of his best discoveries over the years include First Brands Corp., the maker of Glad garbage bags, Prestone antifreeze and STP products — stocks that many people may have passed up in lieu of sexier story lines.

Needless to say, when John took the stage, just after 2:00 p.m. (Pacific time), and said he was going to share his finest investment idea with us, everyone took out their pen and paper. We were all ready to write every detail down. But what he said next made every value guy in the room uneasy — very uneasy.

John’s favorite idea was to invest in the dying newspaper industry — an industry that even Warren Buffett recently said was “heading into the cemetery.” Specifically, he likes Lee Enterprises (LEE:NYSE) and Journal Register (JRC:NYSE) — two small-cap newspaper publishers with hundreds of local papers that have hundreds of thousands of local readers.

When I heard this, I thought to myself, Are you kidding me? The newspaper industry peaked decades ago.

In 1950, 123% of all households got a newspaper (in other words, every houshold bought 1.23 newspapers). By 1970, 62 million papers were sold a day. And since then, it has been all downhill.

Thanks in large part to the Internet, only 53% of all households read the paper today. Circulation is down 6% since 1990. And over the last 20 years, readership has declined 1% (on average) every year.

So why on earth could a smart guy like John Rogers even consider investing in the newspaper industry — let alone have the gall to call it his finest idea? He offered four reasons.

First, there is a cloud over the entire industry. Everyone expects readership to continue to decline, margins to fall and content to worsen. As a result, people have sold all their stock and moved on. For instance, shares of Journal Register (a publishing company with 27 daily papers and 658,000 readers) are trading for historic lows — as you can see from the chart below. And according to the company’s latest annual report, there are only 92 shareholders of record!

John believes now is exactly the time to buy — when no one else has the stones to do it. He doesn’t think newspapers will “go to zero.” And he doesn’t think people will one day simply stop reading. While circulation has declined, John is quick to point out that 54% of adults still read a paper every day and 39% of all young people still read a daily paper. Those are still large numbers.

Second, newspapers (like the ones Journal Register publishes) offer something you can’t get from the Internet — local content. If you live in York, Pa., and want to find a sports score for your high school football team or read about a new restaurant that just opened up down the street, where do you turn? Most people still open up their local paper to find the answers.

As good as the Internet is, it still hasn’t figured out a way to deliver local content the way newspapers do. That means that a lot of papers still have a monopoly on local advertising and classified revenue — which comprises 80% of all publishing revenue. For instance, the New Haven Register is Connecticut’s second largest newspaper. If you have ever been to New Haven, you know that it is a great newspaper town. Yale University is located in New Haven. There is a major hospital nearby. And there are 7,600 stores in the area that are almost forced to buy ad space in the Register.

Rogers doesn’t think that will change anytime soon.

Third, newspapers are finally realizing that they can use the Internet to their advantage — that it’s not just a competitor. Dow Jones & Co., the publishing company that owns The Wall Street Journal and Barron’s, spent $463 million to acquire http://www.marketwatch.com/ in late 2004 — so it could get its hand in the Web business. A quick visit to the site will show you why. There are ads from Lexus, Palm, Fidelity, UPS and a slew of brokers. Those aren’t free. They are bringing in a lot of money — every single day.

Not suprisingly, Web revenues are growing double digits year after year for newspaper companies in general. And although they still only account for less than 5% of total sales (industrywide), John Rogers expects Web sales to account for 50% of total revenues in the next 10 years. If he’s right, not only will these businesses stop declining, they will rise dramatically from current levels.

Finally, the newspaper business is notorious for throwing off huge amount of cash and boasting incredible profit margins. The average newspaper company has a 15% operating margin. And both of Rogers’ favorite small-cap picks, Lee and Journar Register, throw off between $50-100 million in cash from operations a year.

As a deep value investor, Rogers believes that if you simply milked these companies dry — sucking up all the cash and paying it back to shareholders over the next decade — the businesses would be way undervalued, despite the fact that readership is declining.

Rogers calculated that Journal Register is trading for 39% less than its intrinsic value. Lee Enterprises is selling for a 32% discount to its intrinsic value. And his large-cap favorite, Tribune Co. (TRB:NYSE), trades for a 42% discount to its fair value.

At the end of his speech, John reiterated his thought that local papers will make investors a lot of money in the next 10 years. He expects they will rise as much as 10% a year once they get the Web part of their businesses rolling. With that comment, I could hear even the hard value guys in the room choke on their bottled waters.

It’s a rare case when you can make several hundred contrarian value investors uncomfortable all at once. But John did.

After I returned from L.A., I thought a lot about the paper business. And I asked myself this question…

What if papers don’t die? What if these publishers do figure out a way to make money on the Web?

When I thought of what could happen if John is right, I immediately started researching Journal Register (one of the best local publishers on Wall Street) for myself. In my next Sleuth, I will share my findings with you. You can see for yourself whether this is a tremendous opportunity or a classic value trap. Stay tuned…

Until next time,

James
May 25, 2006

Penny Sleuth Contributor

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