Monthly Archives: December 2012

This is How We Invest

It’s a bit of a mystery to me that many people still find value investing so mysterious.  At its very heart is the notion of buying something for less than its true value.  Almost everyone I know likes to buy things when they go on sale, except for stocks.  When stock prices are down, that is to say they are “on sale,” the natural tendency is to sell, not buy.  Funny old world, isn’t it?  Buying in the face of bad news seems to be the most difficult of investment disciplines to acquire.  This is one reason perhaps why so many individual investors, armed only with their common sense and the information flow from the media, tend to perform poorly versus the major indices.

This year, we (my investment colleagues and I) invested in a stock that nicely explains our investment philosophy and practice.  Not every stock we buy will follow this pattern (which is actually a good thing for my blood pressure), but I think sharing this one with the reader may help understand better how we invest.

Sometime in April of this year, I was running my usual screens looking for attractive investment candidates. I use a number of data sorts that can identify stocks that look cheap on a number of measures such as price-to-earnings, price-to-book, price-to-sales, price-to-free cash flow and so forth.  The output from these screens is our starting place in the stock selection process.  Not every stock that looks cheap (inexpensive) should be bought.  Some cheap stocks truly deserve a low valuation.

So in April, I found a company that I had never heard of before.  It was a mid- to small-cap company that looked cheap on a number of the ratios we use.  It operated in a competitive industry, but seemed to have a solid handle on an attractive niche in that industry.  The balance sheet seemed ok and sentiment on the name was mixed.  We usually find these things to be positives as we analyze a stock.

One of our investment policy committee members, ran the numbers, wrote up the report and we discussed the name at length, trying to fully assess the pros and cons of the stock.  In the end, we decided to buy the name, somewhere between $8 and $9, and thought that its “fair value” was around $12.

We started to buy the name with the expectation of making an attractive return.

Very shortly after we started buying the stock, it released a disappointing earnings announcement.  The company was having trouble with pricing, was losing market share and had a couple of other technical issues that were troubling.  Wall Street analysts began to cut price targets and earnings estimates.  Sentiment on the name quickly turned very negative.

We reconvened and reviewed our investment thesis in light of this new information.  After much discussion, we concluded that the news was not a deal breaker and continued to buy the stock.

From early May to early June the overall market struggled and this stock (perhaps because of its now perceived higher risk profile) moved down sharply with the market.  Each week we review the numbers and our investment thesis on this name.  Each week we concluded that the fundamentals continued to suggest a “fair value” much higher than where the stock was trading.

By early July the shares were down about 30% from where we started to buy them.  Although we felt a bit troubled by this move, we continued to buy the stock.  We noted in one of our discussions that the stock, when it was trading below $6, was actually cheaper than the cash on its balance sheet.  The market was practically giving away the stock for free.  And yet, sentiment continued to be very negative and some “experts” were even starting to question the viability of the company as an on-going business.

This was the time that the great investor Sir John Templeton would call the “point of maximum pessimism,” the place that separates good investors from average ones.  Investors who can look this pessimism in the eye and conclude (as we did this time) that the stock should be bought are generally rewarded for their contrarian (and perhaps courageous) stand.

By the middle of July, the market had turned around a bit and so did our little headache.  In late July, we began hearing talk that another company might be interested in acquiring our stock.  The stock moved quickly higher and by September there was an actual bid on the table to take over the company.  Although the deal was a bit complicated, we found it interesting that a bid from a strategic buyer drove the stock price to the exact level ($12) that was our “fair value” estimate back in April.

The chart below shows the trajectory of this stock’s price action.

So here are a few of the key issues about this investment I wish to stress:

1)     No one recommended this stock to us.  We found it on our own, did our own research on it and reached a conclusion that was a bit contrary and wholly our own.

2)     The stock looked cheap in April, but got a lot cheaper before the market (and the strategic buyer) could see its upside potential.

3)     It would have been much easier to give up on this name in May, June or July than to keep liking and buying it.  This would have been a big mistake.

4)     This stock rose to our estimate of “fair value” much faster than usual. This is why I thought it would be an interesting case study, exactly because the time frame was so compressed.

5)     Contrarian investing is not intuitive or easy, otherwise everyone would do it.

6)     We made a very attractive return in this stock.

7)     Your results may vary.

8)      Past returns are no guarantee of future results.

Each month I continue to use my screens searching for the next undervalued and unloved stock.  Each week our committee meets to look at new names and discuss new developments on the stocks we already own.  Every day, I wake up and wonder what new events will affect the markets and my stocks.  It may seem like a volatile and uncertain business to the average (normal?) person, but I really enjoy the entire process with all of its many ups and downs.

What Does Mr. Market Know?

One of the fundamental articles of faith regarding the stock market is its ability to discount future events.  That is to say, stock prices today should (if the discounting mechanism is functioning properly) reflect some of the potential future possible scenarios.  This works (when it works) because (so the theory goes) the smartest investors out there have already decided what they think is going to happen, and have already invested accordingly.  Sure, there are times when this doesn’t seem to work (the financial global crisis of 2008-2009), but most of the time Mr. Market seems to have a good handle on what’s in store.

To the average person, this notion may seem very strange.  How can the market “know” what’s going to happen?  The easy answer is that a lot of analytical power (not to mention money) is expended every day to measure and understand the current state of affairs in the economy, the various industries and each and every company out there.  There are great financial incentives for most professionals to “get it right.”  Collectively, all this brain power and financial heft adds up to a formidable forecasting machine.  This is why many professional investors do things that seem highly contrarian to the casual observer, and why they rarely speak publically about what they are doing right now (why give away your best ideas for free??).

The casual observer may read the newspaper, listen to the nightly news, and talk to some friends about the state of affairs.  Most conclusions about the stock market gathered in this way (excluding insider information, which is illegal) are likely already priced into stock prices.  Said another way, it is rare for an individual investor to do well by simply listening to the media and investing accordingly. By design, the media provides information it thinks will be readily consumed by its customers, not high-quality investment advice.

Right now, the media focus appears to be centered on the so-called “fiscal cliff.”  Each day we can read an article or listen to some “expert” about the dire consequences looming for our nation, its economy and, of course, the stock market.  These stories always sound rational and convincing.  They are obviously designed to be attractive to the consumers of such media.  In my view, they usually have a certain intuitive appeal that makes me not only sit up and take notice, but also want to do something to my portfolio.  Then, I remember that anything I hear in a public forum is mostly likely already reflected in stock prices. I then relax, sit back and enjoy the show.

So let’s boil all this down to the present time.  The consensus feeling out there is that we are facing a catastrophic event that could be horrible for the economy and the stock market.  If this were the case, could we expect this event to be discounted by the market?  I would think so.  Smart money would have already drawn its conclusions about this likelihood and invested accordingly (sold stocks, for example).

So what is Mr. Market saying about the likelihood of the “fiscal cliff” truly damaging the economy or stock market?  Well, through the end of November, the S&P 500 is up nearly 15%.  This has occurred despite slowing corporate earnings, big economic pauses in China and India, a recession in Europe and the looming fiscal cliff.  To put this performance in perspective, there have only been two other years since 2000 (2003 and 2009) with better performance than 2012.  I would submit that Mr. Market is not unduly worried about the market impact of the fiscal cliff.

As always, I don’t make predictions, but I would be very surprised to see a big sell off in stocks due to the shenanigans going on in Washington right now.  If I am surprised and we see some kind of correction, I would view it as a wonderful buying opportunity.  It’s bound to be entertaining – sit back and enjoy the show!