This article is excerpted from Tom Yeung’s Profit & Protection newsletter. To make sure you don’t miss any of Tom’s picks, subscribe to his mailing list here.

June’s No. 1 Profit & Protection Pick… Revealed

On Thursday, I introduced five high-potential picks chosen by the quant-based Profit & Protection system. They ranged from speculative biotech firm 2seventy Bio (NASDAQ:TSVT) to blue-chip BJ’s Wholesale Club (NYSE:BJ).

Now, if I were a quant-based investor with hundreds of long-short positions, I would buy small positions in all five!

But we’re here to make big, meaningful bets that can move the needle of a concentrated, well-researched portfolio.

So today, I’m going to reveal which of the five companies has made it to the no. 1 spot on this month’s Profit & Protection buy list:

RealReal (NASDAQ:REAL).

The Turnaround E-Commerce Play

At first glance, the RealReal looks like a bust when it comes to e-commerce plays. Founder/CEO Julie Wainwright abruptly resigned earlier this week after overseeing a 90% share price drop since its 2019 IPO.

Company morale is at an all-time low. Account managers are routinely overworked and customers are often left frustrated by a lack of service.

I can keep going on about RealReal’s issues. A lack of profitability… low worker pay… shareholder lawsuits… a sagging stock price…

So what’s the good news?

RealReal has become so cheap that it’s now a potential acquisition target.

As the quant-based Profit & Protection pointed out, the firm’s rapid growth rate and improving profitability make its $3-per-share price as tempting as some of its online offerings (Anyone interested in a $150 Salvatore Ferragamo handbag?)

And with a market capitalization that barely breaches $250 million, RealReal has become so cheap that even struggling Groupon (NASDAQ:GRPN) could theoretically make an all-cash offer for its equity.

Big winners are never pretty at the time (just think of Amazon’s (NASDAQ:AMZN) $6 shares in 2001). But at today’s rock-bottom prices, RealReal is more likely to jump 2x to 5x than go straight to zero.

And here’s why.

The Value of Growth

The value proposition for RealReal is straightforward:

Network effects.

The company relies on a positive feedback loop to grow its marketplace for used luxury goods.

The more products listed on the site, the more attractive it becomes for buyers…

… More buyers, in turn, draw more sellers looking for a large audience…

… And so on.

It’s a virtuous cycle that keeps on giving.

That effect has made RealReal a superstar in the used luxury goods industry. The company grew 56% in 2021; analysts expect another 32% annually over the next three years.

There’s also an element of scale. High-profile fakes like a counterfeit $3,600 Christian Dior bag require specialized knowledge to spot, and only scaled-up firms can afford to train such specialized authenticators. These firms are also better equipped to weed out bad sellers trying to pass off fake goods.

And the best part? RealReal still has room to grow.

Analysts at Morningstar expect the online luxury market will quadruple in size to $47.7 billion by 2031 (even the solar industry won’t grow that fast). And REAL has yet to break into the used sneaker trade, high-end art market, wines and other high-value resale markets.

How Bad Can Things Get?

As we saw last week, companies on the verge of bankruptcy unintuitively receive a high quality score in the Profit & Protection system; stock markets have a nasty habit of overestimating the chances of a stock going to zero.

We can trace the phenomenon by mapping out the performance of Russell 3000 stocks over the past decade. The quintile companies with the lowest Altman-Z scores — a quantitative measure of solvency — outperform the other quintiles by 0.6% annually.

The effect is even more pronounced once we remove delisted companies. If an investor could predict which companies would disappear, their outperformance from the lowest quintile Z-scores rise to 8.9%.

That naturally begs the question: Will RealReal go bankrupt?

The short answer:

There’s a 45% to 60% chance it will if nothing changes (but keep reading for some good news).

The company’s $361 million cash hoard is only enough to cover another 20 months of expenses. And analysts don’t expect positive EBITDA profitability until sometime in 2024… a margin so small that I’m counting my fingers and toes to see whether RealReal can make it.

Debt markets agree… and they’re not even taking off their shoes. The company’s 2028 convertible bonds sell for 48 cents on the dollar with a 16% yield to maturity. In other words, RealReal’s financials are in junk bond territory, and credit markets know it.

But in the world of investing, things do change. RealReal’s vast consignor network and rapid growth rate make it a tempting target for a buyout (CEO Julie Wainwright’s resignation also makes it easier to absorb). And a change in stock market valuations could make debt and equity financing far cheaper.

I estimate that investment bankers will start sniffing around at $2.50/share, and offers come in no lower than $2.00.

And if stock markets do recover this summer, the company could raise an additional $200 million to cover another year or so of expenses. Price-per-share could easily hit $15 within three years.

What’s RealReal Worth?

Together, that means an investment in RealReal has three potential outcomes*:

• Bankruptcy: $0.
• Acquisition: $2.50 (worst-case)
• Success: $15

(*This figure ignores discount rates to avoid double-counting bankruptcy risk.)

Assigning a one-third chance to each outcome prices RealReal at a conservative $5.80, a 95% upside.

Aggressive investors could value RealReal even higher. Decreasing REAL’s chance of bankruptcy to 20% and raising its acquisition price to $5.00 puts its fair value closer to $8.00, a 160% upside.

Either way, RealReal’s potential acquisition value gives a reasonable “Protection” element to this otherwise high-risk bet. And though you won’t want to put more than a small portion of your portfolio into this investment, the Profit & Protection investment system suggests that these fast-growing turnarounds generally outperform.

How to Play Risky Bets

Hertz (NASDAQ:HTZ) at $2…

Kohl’s (NYSE:KSS) at $35…

Maybe even GameStop (NYSE:GME) at $4…

Companies can sometimes become so cheap that they become buyout targets.

But not every company gets a lifeline from white-knight investors.

Consider Sears and JC Penney, two century-old companies that vanished from stock markets.

In both cases, the value of these retailers’ debt and lease obligations far outweighed any “residual value” from their saleable assets. No blue-light special could save Sears shareholders from getting nothing.

So why did these storied retailers vanish while Kohl’s is getting a buyout deal?

It all comes to the value of hidden assets.

Kohl’s ownership of prime-grade retail locations makes it far more attractive than its balance sheet implies. Sears, on the other hand, famously inflated the value of its real estate holdings.

Other times, companies like RealReal are attractive for its network effects. These are valuable assets that don’t show up on typical balance sheets.

Regardless, these potential takeover targets provide some measure of protection from shares going to zero. And though not each of these companies survives, investors are still statistically better off betting on these moonshots than waiting for the perfect investment to arrive.

P.S. Do you want to hear more about cryptocurrencies? Penny stocks? Options? Leave me a note at feedback@investorplace.com or connect with me on LinkedIn and let me know what you’d like to see.

On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.

Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.