Stock market corrections are both natural and necessary. We need the occasional corrections to sell our under-performers and exchange them for better firms with greater potential that are now back in a reasonable buy range. Let me explain by way of analogy:
Not long ago, we had quite the controversy up here in the High Country surrounding Lake Tahoe. Those of us who had seen firsthand the benefits of controlled burns in European and other forests were concerned about the massive underbrush ("ladder fuel") that was taking over the forest floor — highly flammable manzanita, bitterbrush, mule ear and sage were left to grow until they were just inches from the lowest branches of our beautiful Ponderosa and Jeffrey pines. Plus, there were a number of dead pines that had been struck by lightning once upon a time or succumbed to pine disease, and these were perilously close to the healthy trees. We advocated for brush and dead tree removal. All the area fire departments agreed with us.
Regrettably, a less-informed constituency weighed in against such a common-sense plan. They seemed to think it was somehow violating Nature's plan if we did our best to prevent death and destruction. Their argument went something like this: "Dude, don't mess with the trees, man. This is the way it is and it's beautiful. And, besides, like, where would all the little woodland creatures hide if you take away their cover? No way do we interfere with nature."
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- IBM 15-Year Financial Data
- The intrinsic value of IBM
- Peter Lynch Chart of IBM
We unenlightened did not share their concern that the mice, voles and other rodents be allowed to reproduce freely, frolicking undetected under all that dead wood and weed. We felt it our duty, however, to point out that preventing fires might be a reasonable counter-argument — and that while populations of voles and mice were exploding, their natural predators like eagles, owls and hawks were in decline or starving — which was already "messing with nature."
They won the argument. Our bi-state "planning" agency which must approve the removal of a grain of dirt from a private residence was swayed not by science, but by the size of the very vocal crowd at the public hearings.
Then they lost. We all lost. The Angora fire that summer spread so rapidly through the underbrush that many residents had as little as five minutes to vacate their homes before the fire reached them. In the eight days it took to bring it under control, 254 homes were destroyed, 3000 people were evacuated, $150 million in damage was sustained, the loss of tourist visits that summer was estimated at $1 billion and, a huge swath of our 100-year old trees were reduced to sticks of charcoal. Miraculously and fortunately, there were no deaths.
The devastation caused by this dangerously uninformed group-think made all residents realize that the forests in which we live up here need to have the dead kindling and ladder fuel burned off and the nutrient-rich charcoal returned to the ground.
Likewise, markets, to remain healthy, must do the same from time to time. If we allow the ladder fuel to build and build and build, markets get toppy and it takes what at the time may seem the most innocuous of events to topple it over. In the marketplace, instead of tinder-dry weeds and oil-laden shrubs, it is companies that are bid up simply because all the good companies were already standing tall, so next people buy, simply because they are cheap, the Enrons and Pets.coms. (Great sock puppet; lousy business plan.)
On the other hand, if we have regular corrections of a few percent on our way to rise again, it gives the markets new life. And gives us long-term value investors the chance to plant some strong young trees without having to slash our way through the rodent-infested mule ear and bitterbrush!
The "controlled burn" we are currently in hasn't changed the Fed's outlook nor our firm's outlook.
- The U.S. economy is improving slowly but still improving every month.
- The politicians realize their brinksmanship, recalcitrance and petulance did not play well on Main Street and are now eager to create budgets, adjust debt ceilings, encourage trade and almost earn their keep.
- There is reason for optimism as the mid-year elections approach.
- The market is a good indicator of the economy. If the economy is seen to be improving down the road, the "big trend" of the market reflects it today.
We never invest just because the market is rising — that's exactly why most investors lose over time. They get excited and then don't sell because they don't believe in corrections/controlled burns. Instead, they watch their entire portfolio go up in flames.
As we wrote in our December issue of The Investor's Edge: "Yes, there is likely to be a correction sometime in the coming weeks or months. But unlike my caution of earlier this year, based on the changed fundamentals I don't believe it will be severe." (It seems we are now in that correction.)
No matter where we are in the market cycle, if the only reason your stocks are going up is because the market is going up, when the market declines it stands to reason your stocks must also decline. That's why we don't mind seeing corrections; the opportunity to quietly survey the scene and select the best of those firms that have come down with the rest of the market adds value to our portfolios.
We recently added IBM (NYSE:IBM) and Oracle (NYSE:ORCL) at, respectively, 12 and 14 times earnings to our model portfolios. We also bought Microsoft (NASDAQ:MSFT) for some clients and Cisco (NASDAQ:CSCO) for others. Take a look at this chart I found from a few months back, courtesy of Carla Fried at Y-Charts:
EV/EBIT, or Enterprise Value divided by Earnings Before Interest and Taxes is a pretty good proxy for real earnings ex any cash hoard. It's a good measure of value because a company should not be expected to earn the same on cash as it does in its business lines — but that cash sure is nice to have in tough times! Think of this as an ex-cash trailing PE ratio. (EBITDA adds "depreciation and amortization" to the equation.) All three firms above sell for single digit EV/EBIT and IBM (not shown) is just 10.2. Since this correction began you may now buy all four at an even lower price. These are just a few of the companies we are buying to move up in quality while they are cheap.
The Fine Print: As Registered Investment Advisors, we believe it is our responsibility to advise that we do not know your personal financial situation, so the information contained in this communiqué represents the opinions of the staff of Stanford Wealth Management, and should not be construed as personalized investment advice.
Past performance is no guarantee of future results, rather an obvious statement but clearly too often unheeded judging by the number of investors who buy the current #1 mutual fund one year only to watch it plummet the following year.
We encourage you to do your own research on issues we discuss to see if they might be of value in your own investing. We take our responsibility to offer intelligent commentary seriously, but it should not be assumed that investing in any securities we are investing in will always be profitable. We do our best to get it right, and we "eat our own cooking," but we could be wrong, hence our full disclosure as to whether we own or are buying the investments we write about.