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Thoughts on Finding Value When Stocks Are Making New Highs

July 13, 2013 | About:
I've been traveling for the last two weeks, and thus the reason for the lack of posts. But I've been working and reading as usual, and have been actually active in making a few investments, despite the overall market climbing to new highs. I've mentioned this before, but it's worth saying again: I put almost no emphasis on what the overall market is doing and where the indices are. I simply look for undervalued stocks.

But regardless of the methods involved in making investments, with a rising market comes rising risk. One of the ways I choose to lower my risk is by simply looking for depressed prices. As readers of this blog know, I love simplistic and basic thinking. One of the basic ways to think about stock prices is:

When stock prices rise, risk rises. Conversely, when they fall, risk falls.

This obviously assumes all other fundamentals remain constant, which isn't always true, but on a day-to-day basis, it generally is.

Where Are the Values?

So if rising stock prices raise risk, then it would be natural to want to look where stock prices are going down, and thus lowering investment risk. This is probably why many value managers like to look at the 52-week low list. I like this list too, but there are other lists I like better, such as the stocks that have fallen the most in the last month, quarter or year. One of my favorite ways to gauge sentiment is by looking at Value Line's list of 98 industries that they rank each week. Momentum exists, and so many of these cheap stocks get cheaper. But one thing I've learned about market anomalies: Mean reversion almost always beats momentum in the long run, especially when you're considering momentum on the downside.

Taking a quick scan of any of these lists, you'll notice many stocks in the metals and mining industries keep showing up. Precious metals is one of the worst ranked industries in Value Line, and many gold and silver mining stocks have lost 50% to 75% of their value in the last six months alone.

Look to the Balance Sheet First for Risk Management

I'm very much a Graham and Dodd investor, so I like to look at balance sheets first and foremost. My favorite investor is Walter Schloss, and he too studied the balance sheet first. I think the reason for this was not that the balance sheet provided better insight into the potential for investment profits, but that the balance sheet provided a better view of the risk of the stock. One of the key things I learned from studying Schloss is that one of the best ways to reduce risk is to own businesses with low debt and good liquidity.

This is especially true when looking at stocks on new low lists. Many of these stocks are bad businesses, and many will go bankrupt if they are not adequately capitalized.

So when looking at new low lists or other basic value lists, look for stocks with low debt to equity ratios and high current ratios (current assets less current liabilities: a back of the envelope way to judge liquidity, i.e. how likely a business is to be able to adequately meet its short term obligations to stay in business).

Herd Behavior Causes General Mispricing: Be Contrarian

When the majority doesn't like a stock or a group of stocks, these stocks tend to get mispriced. It goes back to the Greenblatt Magic Formula idea that some of these stocks will go down, some will go up, but on balance, you can own a group of stocks that provide good odds of outperforming.

The basic logic is that the stocks have all priced in the current bad news and poor business environments. If the bad news materializes, that is what is expected, so you hypothetically won't lose much. If any bit of good news occurs, or if the business improves or industry fundamentals turn around, or if there is any positive surprise, the stock can have significant upside.

So on balance, you can build a portfolio that has an average risk reward ratio that is asymmetrically skewed to the upside. Graham likened owning a group of undervalued securities to the insurance underwriting business: In a life insurance portfolio of 1,000 lives, there will likely be 6 or 8 unexpected deaths that will cost the insurance company in a death claim. The company obviously doesn't know in advance who the unfortunate people will be, but they know that with proper underwriting, they will achieve profits on the overall portfolio of lives.

In investing, the idea is that some stocks will be losers, but on balance, the winners more than compensate for the losers. This philosophy is how Walter Schloss made 21% per year for nearly 50 years.

Quick Comment on Graham/Schloss vs Buffett Philosophy

Graham and Schloss ran their portfolios much differently than Buffett and many of the other talented investors of today. The two key differences were that Graham and Schloss chose to be diversified and they allowed themselves to own businesses without competitive advantages. The latter is probably the reason for the former. Unlike Buffett, who wants his margin of safety in large part through the quality of the business, Graham and Schloss wanted their margins of safety through the valuations of the business. They wanted to own cheap stocks. But they took their margin of safety concept one step further: They didn't just want cheap stocks, they wanted a lot of cheap stocks. So they established their safety margins through the individual securities, and also through diversification at the portfolio level.

I've talked about these differences before between Buffett and Graham, and why I think most individual investors would benefit by adopting a philosophy closer to Graham. It's a very interesting topic to consider. But value investors come in all different variations, and there are many talented Buffett-style investors to learn from.

Buffett wouldn't own many of the stocks I'm currently looking at. One group that many value investors eschew is the precious metals industry. Buffett wouldn't own gold stocks. I can't really blame him. They have no competitive advantages. They are tied to a commodity that is basically impossible to price intrinsically. But Schloss did own some gold stocks, commodity stocks and other capital-intensive businesses.

He wasn't the only one. Templeton did, Graham did, Neff did and many other great investors did. It's not that they liked the businesses, or the industries, or that they had portfolio allocation requirements, etc. It's simply that they owned the stocks that were cheap. They didn't care much about competitive advantages or long-term business prospects. They assumed they were no better than the average professional in judging business prospects. So they chose to buy cheap stocks.

Later this week, I'll discuss why I invested 5% of my portfolio into a basket of well-financed gold and silver miners, and why I think that despite the difficulty in valuing the businesses, that a margin of safety exists and why I think there could be asymmetric returns on the upside: "Good things happen to cheap stocks."

Have a great weekend!

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About the author:

John Huber
I am the Portfolio Manager at Saber Capital Management, LLC. Saber manages an investment partnership as well as separately managed accounts for clients interested in a focused value investing strategy. My investment style has been most influenced by Ben Graham, Walter Schloss, Warren Buffett, and Joel Greenblatt. I am also the author of www.BaseHitInvesting.com, a value investing blog.

Visit John Huber's Website


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Comments

Cornelius Chan
Cornelius Chan - 9 months ago
Momentum exists, and so many of these cheap stocks get cheaper. But one thing I've learned about market anomalies: Mean reversion almost always beats momentum in the long run, especially when you're considering momentum on the downside.

Didn't know this. (I assume the author has done lots of study to verify the claim) I sure hope it is true as I own quite a few gold & silver stocks. LOL

I think the reason for this was not that the balance sheet provided better insight into the potential for investment profits, but that the balance sheet provided a better view of the risk of the stock.

Couldn't agree more. This is the concept that is front-center in my mind as I look at balance sheets.

It's not that they liked the businesses, or the industries, or that they had portfolio allocation requirements, etc. It's simply that they owned the stocks that were cheap. They didn't care much about competitive advantages or long-term business prospects. They assumed they were no better than the average professional in judging business prospects. So they chose to buy cheap stocks.

This is an excellent point. The author's point about the difference between Buffett and Schloss whereby the former is majority business quality and the latter price is well taken. Especially since it is apparent the author has done lots of study on Buffettology.

Overall, another well written article from John Huber. I like the closing caption: "good things happen to cheap stocks." Like it a lot :)

Bob_in_Maryland
Bob_in_Maryland premium member - 9 months ago
What should an investor require when considering a given security, when basing that determination on varying degrees of risk?

The capital asset pricing model (CAPM) was developed in the 1990’s. Until that point in time, apparently, investors lived without a “compass” as to how an asset’s risk might be determined. Understanding the concept of this model can allow an investor to avoid individual losses and construct trading rules that will lead to adaptability.

One significant step in attaining such a degree of flexibility is to abandon – or at least, seriously reconsider - the buy and hold paradigm advanced by certain, prominent, investors.

Losses can teach us that there is a great deal more involved with diversification than just “risk reduction”.

IF “value investors” and “momentum investors” trade within their within their own bubbles, it’s their loss. Seems to me, that a loss of more than – let’s say – 7 or 8% on a single investment is too high a price to pay. Even though the overall return to a portfolio might provide return; the opportunity cost assigned to holding a losing security skews the risk-return consideration to a portfolio.

“Momentum investors” have their own set of values. Focusing on those values can allow for the construction of rules that will allow for an accommodation between risk and reward. One useful and constructive outcome from the losses incurred by those who took recent losses in sectors like precious metals would be to engage on these matters.

Dr. Paul Price
Dr. Paul Price premium member - 9 months ago


Very nicely done.

A good article that was well thought out.

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