The S&P 500 is up close to 60% since the March trough. You would think that investors, especially retail ones, were enjoying the ride. Unfortunately, they are sitting on the sidelines and have missed one of the greatest bull-market runs in a long time.
The bear market of 2008 knocked the stuffing out of most investors’ retirement portfolios. After reaching an all-time high in October 2007, the S&P 500 fell more than 56% by the first week of March 2009. After the second bear market in a decade, retail investors had just about enough with stocks. By extrapolating to the future the pain of losing money twice in the past 10 years, investors decided to sell stocks at rock-bottom valuations and invest in money markets that paid next to nothing.
Instead of looking at stocks as pieces of businesses, investors chose to view them as lottery tickets. And when stock prices sank, investors were not in the right state of mind to comprehend that many of the stocks they owned were trading for considerably less than the underlying worth of the businesses.
Since the beginning of this year, mutual funds and exchange-traded funds that are dedicated to U.S. equities have had a net outflow of $53 billion[1]. Where did most of this money flow? While some did find its way into bond funds, the majority of it went into money market funds paying next to nothing. More than $3.3 trillion is sitting in money market funds yielding less than 0.25%. To put this in simpler terms, for every $100,000 in a mutual fund money market, retail investors are earning $250 in dividends. Retail investors couldn’t buy stocks quickly enough on the way up and couldn’t sell them fast enough on the way down.
The bottom
It’s pretty easy to look back in time and show a great return from the market bottom in March, but in all fairness we have to keep in mind what the stock market looked like at the close of the day before it hit bottom.
Investors were already burned twice before, when financial gurus proclaimed that market lows had already been made. The low of October 2008 was replaced by a lower low in November, which was replaced by an even lower low in March 2009. The first two months of 2009 were dreadful, with the stock market down more than 20%. For retail investors, that was the point they cried uncle, threw up their hands and gave up investing in stocks.
To those who allowed price to dictate value, the stock market did indeed look like a very gloomy place. However, for a small group of investors that let the fundamentals of the company dictate the value of the business, it was a once-in-a-generation opportunity.
Followers of Benjamin Graham understood that over the short term, the stock market values businesses based on their popularity. But over the long term, the stock price reflects the underlying worth of the businesses. Most of the time, the stock market is an efficient arbiter of value. But at the emotional extremes (fear and greed), it overshoots, valuing businesses way below their worth during times of fear and way above their worth during times of greed.
No revisionism
During periods of extreme fear, stocks are priced very inefficiently. I looked back at several of the stocks that were in the Inevitable Wealth Portfolio (IWP) on Jan. 27, a little more than five weeks before the stock market low. The P/Es of Corning Inc., ConocoPhillips, Tyco Electronics and Garmin Ltd. were less than 4. Even though these companies had rock-solid balance sheets, Mr. Market was offering them at $4 dollars for every dollar of earnings, and investors still weren’t interested!
Low P/E stocks in IWP on January 27, 2009
Even at P/Es of 4 or less, investors weren’t interested
Within the past five years, these same stocks were trading at P/Es that were in the stratosphere, and investors couldn’t buy enough of them. But when Mr. Market was depressed, he was practically giving away these companies and there were no takers.
Proper framework
The approach that we use in IWP is one that attempts to stick to logic and not emotion when making investment decisions. Investors in the first part of the year were making their investment decisions based on emotion. Does it seem logical to sell a stock at the time it is selling for a fraction of the worth of the underlying business, and then to invest the proceeds into a money market earning practically nothing?
An investor has to be mentally prepared to act when Mr. Market pushes prices to the extremes. Legendary value investor Sir John Templeton looked for areas in the market that had the most miserable outlook. He called this the “principle of maximum pessimism,” and it was there he found the best bargains. He said,
There is only one reason a share goes to a bargain price: because other people are selling. There is no other reason. To get a bargain price, you’ve got to look for where the public is most frightened and pessimistic.
In order to be a buyer when others are selling, you need to have the proper framework. When pessimism is at its peak, we follow our rules and buy companies that have bulletproof balance sheets and are trading at a discount. We don’t allow doubt, fear or any other emotion get in the way of making a logical, rational decision based on a proven approach.
Most of the time, we are sifting through companies trying to find the ones that are mispriced relative to the underlying businesses. When the opportunity presents itself, we act. Charlie Munger, vice chairman of Berkshire Hathaway, summed up our approach when he said,
A few major opportunities, clearly recognizable as such, will usually come to one who continuously searches and waits, with a curious mind, loving diagnosis involving multiple variables. And then all that is required is a willingness to bet heavily when the odds are extremely favorable, using resources available as a result of prudence and patience in the past. Opportunity comes, but it doesn’t come often, so seize it when it does come.
As a subscriber who follows the approach we use in IWP, you distinguish yourself from the herd. While most investors, both big and small, were frozen like deer in headlights earlier this year, we acted. Instead of making decisions out of fear that turned out to be bad ones, we used an approach and a framework that prepared us to take advantage of those times when Mr. Market became irrational. This is the way real wealth is made in the stock market.
_____________________________
Charles Mizrahi is the editor of The Inevitable Wealth Portfolio, a monthly newsletter on value investing. This article appeared in the November 2009 issue. He is also the author ofGetting Started in Value Investing (Wiley 2007).
[1] The Lex Column, Attention to Retail, Financial Times, Oct. 27, 2009.
The bear market of 2008 knocked the stuffing out of most investors’ retirement portfolios. After reaching an all-time high in October 2007, the S&P 500 fell more than 56% by the first week of March 2009. After the second bear market in a decade, retail investors had just about enough with stocks. By extrapolating to the future the pain of losing money twice in the past 10 years, investors decided to sell stocks at rock-bottom valuations and invest in money markets that paid next to nothing.
Instead of looking at stocks as pieces of businesses, investors chose to view them as lottery tickets. And when stock prices sank, investors were not in the right state of mind to comprehend that many of the stocks they owned were trading for considerably less than the underlying worth of the businesses.
Since the beginning of this year, mutual funds and exchange-traded funds that are dedicated to U.S. equities have had a net outflow of $53 billion[1]. Where did most of this money flow? While some did find its way into bond funds, the majority of it went into money market funds paying next to nothing. More than $3.3 trillion is sitting in money market funds yielding less than 0.25%. To put this in simpler terms, for every $100,000 in a mutual fund money market, retail investors are earning $250 in dividends. Retail investors couldn’t buy stocks quickly enough on the way up and couldn’t sell them fast enough on the way down.
The bottom
It’s pretty easy to look back in time and show a great return from the market bottom in March, but in all fairness we have to keep in mind what the stock market looked like at the close of the day before it hit bottom.
Investors were already burned twice before, when financial gurus proclaimed that market lows had already been made. The low of October 2008 was replaced by a lower low in November, which was replaced by an even lower low in March 2009. The first two months of 2009 were dreadful, with the stock market down more than 20%. For retail investors, that was the point they cried uncle, threw up their hands and gave up investing in stocks.
To those who allowed price to dictate value, the stock market did indeed look like a very gloomy place. However, for a small group of investors that let the fundamentals of the company dictate the value of the business, it was a once-in-a-generation opportunity.
Followers of Benjamin Graham understood that over the short term, the stock market values businesses based on their popularity. But over the long term, the stock price reflects the underlying worth of the businesses. Most of the time, the stock market is an efficient arbiter of value. But at the emotional extremes (fear and greed), it overshoots, valuing businesses way below their worth during times of fear and way above their worth during times of greed.
No revisionism
During periods of extreme fear, stocks are priced very inefficiently. I looked back at several of the stocks that were in the Inevitable Wealth Portfolio (IWP) on Jan. 27, a little more than five weeks before the stock market low. The P/Es of Corning Inc., ConocoPhillips, Tyco Electronics and Garmin Ltd. were less than 4. Even though these companies had rock-solid balance sheets, Mr. Market was offering them at $4 dollars for every dollar of earnings, and investors still weren’t interested!
Low P/E stocks in IWP on January 27, 2009
| Past 5 Year | 1/27/09 | |||
| Company | High P/E | P/E | Industry | Market Cap |
| Corning Inc. | 58 | 3 | Communications Equipment | $15,543 |
| ConocoPhillips | 13 | 4 | Oil & Gas - Integrated | $71,828 |
| Tyco Electronics Ltd. | 54 | 4 | Electronic Instruments | $7,157 |
| Garmin Ltd. | 23 | 4 | Scientific Instruments | $3,587 |
Even at P/Es of 4 or less, investors weren’t interested
Within the past five years, these same stocks were trading at P/Es that were in the stratosphere, and investors couldn’t buy enough of them. But when Mr. Market was depressed, he was practically giving away these companies and there were no takers.
Proper framework
The approach that we use in IWP is one that attempts to stick to logic and not emotion when making investment decisions. Investors in the first part of the year were making their investment decisions based on emotion. Does it seem logical to sell a stock at the time it is selling for a fraction of the worth of the underlying business, and then to invest the proceeds into a money market earning practically nothing?
An investor has to be mentally prepared to act when Mr. Market pushes prices to the extremes. Legendary value investor Sir John Templeton looked for areas in the market that had the most miserable outlook. He called this the “principle of maximum pessimism,” and it was there he found the best bargains. He said,
There is only one reason a share goes to a bargain price: because other people are selling. There is no other reason. To get a bargain price, you’ve got to look for where the public is most frightened and pessimistic.
In order to be a buyer when others are selling, you need to have the proper framework. When pessimism is at its peak, we follow our rules and buy companies that have bulletproof balance sheets and are trading at a discount. We don’t allow doubt, fear or any other emotion get in the way of making a logical, rational decision based on a proven approach.
Most of the time, we are sifting through companies trying to find the ones that are mispriced relative to the underlying businesses. When the opportunity presents itself, we act. Charlie Munger, vice chairman of Berkshire Hathaway, summed up our approach when he said,
A few major opportunities, clearly recognizable as such, will usually come to one who continuously searches and waits, with a curious mind, loving diagnosis involving multiple variables. And then all that is required is a willingness to bet heavily when the odds are extremely favorable, using resources available as a result of prudence and patience in the past. Opportunity comes, but it doesn’t come often, so seize it when it does come.
As a subscriber who follows the approach we use in IWP, you distinguish yourself from the herd. While most investors, both big and small, were frozen like deer in headlights earlier this year, we acted. Instead of making decisions out of fear that turned out to be bad ones, we used an approach and a framework that prepared us to take advantage of those times when Mr. Market became irrational. This is the way real wealth is made in the stock market.
_____________________________
Charles Mizrahi is the editor of The Inevitable Wealth Portfolio, a monthly newsletter on value investing. This article appeared in the November 2009 issue. He is also the author ofGetting Started in Value Investing (Wiley 2007).
[1] The Lex Column, Attention to Retail, Financial Times, Oct. 27, 2009.
