By the late fall of 2008, most investors had become much more than timid; many had fallen into a wholesale panic as the market indices continued to close decidedly lower, day after day. During such times, successful investors need to muster up sufficient courage to fight off the gnawing sense of imminent doom which overwhelms their psyche. For many, the pressure simply became too great and the urge to jettison their entire stock portfolios overwhelmed any rational sense of self-assurance which argued that all market drops must eventually subside. When the biological instincts of a human being engage in direct combat with the rational mind, it is the instincts that claim victory in the vast majority of these battles.
If I could provide only one piece of timeless advice to all investors, it would contain the following edict: Never sell out your holdings during periods of investor panic or during periods of extreme market pessimism. In other words, never allow yourself to be bullied by emotion, since ultimately that is the time when real value presents itself. Alas, that is easier said than done.
Mohnish Pabrai pointed out in late 2008 that investors must work quickly when opportunity presents itself. When markets suddenly drop, an investor has a limited period of time to identify and purchase the supreme bargains that temporarily present themselves. Should an investor vacillate or decide to wait for a security to bottom, they risk losing the opportunity to purchase a stock at a price well below its intrinsic value.
In retrospect, such common sense is easily employed; however, in the midst of a dizzying decline in the market price of equities, most stock market participants are more interested in immediate capital preservation rather than purchasing stocks at a discounted price. Imagine the reception that a financial adviser would have received had he uttered Buffett’s famous proclamation to a client during the fall of 2008: “Be greedy when others are fearful and fearful when others are greedy.” While the advice would have paid off handsomely in the long run, in the interim the adviser would have likely been seeking out new clients or more probably, he would have been pursuing an alternative profession.
The Investing Climate in the Autumn of 2008
In October of 2007, the Standard and Poor's 500 index set a record high of 1576; by Nov. 1, 2008, the index had declined to 970. The painful retreat would continue until the index would eventually bottom in March of 2009, at a price of 683. It is hard for most investors to recall the emotional anguish that resulted from the incessant drop in the value of their investment holdings and the monthly torment that the savers endured when they opened their 401K statements.
While it may have not been apparent to the average person at the time, the only way that an investor could materially damage the quality of their retirement was to sell out of their stock market holdings. Unfortunately, nervous investors were redeeming their investment holdings in record numbers. As the relentless drop in the stock market continued, more and more investors would sell out of their positions. The result was a permanent loss of capital which could have been easily avoided had the savers merely fought off their emotional responses to the precipitous market declines.
By the time of the Lehman Brothers collapse in September of 2008, the bear market in the S&P was already well underway. Since its peak in October of 2007 the market had retreated close to 30 percent. It would be approximately one month later when Buffett would issue his famous “Buy American” call. Buffett made the following observation:
“Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.”
Although Mr. Buffett could have been accused of being slightly early in his prognostication of the future fortunes to be earned in the S&P, his statement turned out to be prophetic. Indeed, the market would turn positive approximately five months later, well before the leading economic indicators recovered and even longer before average investors would change their opinions about the efficacy of recommitting capital to the stock market.
Investors who maintained their faith in the long-term prospects of American business were rewarded with the buying opportunity of a lifetime. Many high-quality businesses sunk to cyclically adjusted price to earnings ratios which had not been seen for several generations and a number of small companies began trading at sizable discounts to their net current assets. Not since the great depression had investors been accorded such a plethora of bargains, with the only caveat being that investors needed to purchase shares in businesses which would be able to survive the financial crisis.
By early 2009, the investing climate had become tantamount to a period almost 80 years prior when Benjamin Graham had pondered whether American businesses were worth more dead than they were alive. A few years later as the market recovered, it was almost impossible to fathom how investor sentiment could have ever turned almost universally negative.
It is my opinion that the irrational nature of the extreme pessimism was greatly enhanced by the timing of the election of Barack Obama.
At no point in my lifetime had I witnessed such vitriol and divisiveness on stock message boards. Discussions about the merits of individual companies had rapidly degenerated into sheer political wrangling, and the combatants had become blisteringly hostile towards one another. It appeared to me that the line which separates politics and investing sensibility had been hopelessly breached by an exorbitant amount of individuals.
Even normally sensible individuals were drawn into the extensive hyperbole about the impending demise of America and its effect upon their individual stock portfolios. It seemed that this misguided political exaggeration coupled with the daily drops in the stock indexes had formed a particularly toxic brew in regard to investor sentiment. It also unveiled an ugly side of human nature that I hope I never witness again.
In the end, the aforementioned toxic brew of investor sentiment provided value investors with a smorgasbord of equities from which to choose. Even athletically challenged individuals are capable of making “lay ups,” and investors who were not dismantled by fear found themselves standing directly under the basket with a ball in their hands. What really mattered at that time was the courage to invest capital into the stock market rather than the ability to select an undervalued equity.
Devising an Investing Strategy to Emerge from Bear Market
During periods of irrational market pessimism, successful investing is largely a function of only two factors: First, the investor must stay highly invested in the market (easier said than done) and secondly, the investor must forgo the use of leverage. I added a third caveat to the aforementioned factors: I did not invest in any companies that held high debt to equity ratios. Heavy debt loads can put businesses in extreme peril during extended periods of economic slowdowns, particularly if the business is cyclical in nature.
Contrary to classic value theory, it is my belief that investors should sometimes tailor their investment strategy to the current economic situation. In late 2008, the credit crisis set off a wave of deflationary pressures throughout the world economy, thus creating buying opportunities in a vast array of different businesses. However, to me, the most enticing investments which held the greatest margins of safety lay in the tiny economically sensitive stocks which were suddenly trading at large discounts to their net current assets.
During periods of excessive deflation, the value of a company’s current assets holds a greater significance than the value of its fixed assets. Exactly the opposite is true during periods of excessive inflation. The reason lies in the reality that descending interest rates increase the value of assets which are easily converted to cash. During deflationary times, “cash is king,” but receivables and inventory are the next best thing so long as they are realistically convertible into cash.
On the other hand, companies which hold large amounts of their assets in plants and equipment tend to suffer mightily during deflationary times since their expense ratios are highly leveraged to the output of their sales. During such times opportunistic companies with sufficient liquidity are sometimes able to purchase the fixed assets of struggling companies at prices well below their intrinsic value. Cash and current assets not only provide liquidity and security, they also provide opportunity.
I added one more piece to my investment puzzle; I endeavored to identify companies that were increasing their cash flow from operations without regard to the gains or losses of their accrual earnings. In fact, I preferred companies that were showing losses on their income statements since such companies were being offered at the greatest discounts to their underlying value.
Hardinge (HDNG) the Perfect Fit to the Investment Puzzle
Several years earlier I had started following the machine tool sector and I became quite familiar with Hardinge. Although I never invested in the stock (I had opted for Hurco), I had noted that Jeffrey Gendell had been purchasing shares the company. Hurco (HURC) had much higher margins and it was my belief that the superior quality of their computerized machine tools and their accompanying software were reflected in their earnings. Hurco also held a vastly superior balance sheet at the time I made my investment.
As it turned out, Hardinge made an extremely opportunistic secondary stock offering in the spring of 2007. The company had raised around $50 million in cash by selling shares of its stock in the mid-twenty dollar range; a price that significantly exceeded my calculated intrinsic value of the company. Many shareholders openly display contempt when a company dilutes its shares by issuing private placements or secondary offerings; however, if the share price of the company is substantially overvalued, the strategy can create long-term value while strengthening the balance sheet of the business.
Bear in mind that I would never invest in a company based merely upon the fact that it issued shares at inflated prices, but if the company falls sufficiently in price then a buying opportunity might emerge. The strategy of broken IPOs and secondary offerings should exist in every investor’s play book. In the case of HDNG, that strategy would eventually emerge in spades.
By the middle of 2009, HDNG had dropped to a price of under $4 per share. I had started buying the company when its share price had approached $4 and when the stock dropped lower, I bought thousands of additional shares. In a matter of weeks, HDNG became my largest position and with each earnings report, the fortunes of the company appeared slightly better.
At $4 per share HDNG was trading at about one-quarter of its tangible equity and well under one-half of its net current assets. Its market cap had fallen to a price which was less than the amount of cash that the 2007 secondary offering had injected into the balance sheet of the company. Luckily for me, the price would continue to fall and I would be able make HDNG one of the largest investments that I had ever made in a single holding.
I considered my investment in HDNG to contain almost no risk due to its obscenely low valuation metrics, its emerging cash flow from operations and the strength of its balance sheet. In early 2010, an unsuccessful bid to acquire the company was made by Romi for $8 a share. The bid was subsequently raised to $10 per share, but the management of HDNG was successful in fighting off the hostile takeover attempt.
Orbotech (ORBK) and Rudolph Technologies (RTEC) Sizable Net-Nets in the AOI Sector
As noted previously, I rode the elevator up and then back down on Camtek (CAMT), a tiny Israeli automated optical inspection (AOI) company. By late 2008 the company had fallen to below $1 per share. Both of Camtek’s larger rivals, RTEC and ORBK, had dropped to absurdly low levels by November 2008. I used the opportunity to switch out of CAMT and some of my other losing propositions in favor of these superior companies. In the process, I created a large amount of tax loss carry-forwards which would allow me to minimize my future taxation when I decided to sell these cyclical entities.
RTEC was now available for sale at a price of less than $2.5 per share, a level which valued the company at slightly over 50% of its net current assets. Equally important was the fact that RTEC was clearing its inventories and collecting its receivables, in addition to holding nothing in way of long-term debt. In 2008, the company would generate over $12 million in free cash flow while holding a market cap of around $75 million. In the previous two years, the company had generated a combined free cash flow in excess of $35 million. In other words, the liquidity and the future solvency of the company did not appear to be an issue. The valuations for ORBK were equally appealing.
Another huge benefit which was imbedded in the value of RTEC was the tens of millions of net operating losses (NOL) that the company had accrued as a result of the massive accrual losses it would sustain during the credit crisis. These benefits were not reflected on the balance sheet but they would translate into tens of millions of dollars in income tax savings when the company eventually returned to profitability.
The final edition of “Reflections from Twenty Years of Investing” will include the years from 2010 to the present. It will also contain a summary and an epilogue which will address the true value of successful investing.