Wednesday, July 19, 2006

Good News, Bad News: Even Ben Doesn't Know?

There is the story of the old Chinese farmer whose only horse ran off with some wild horses that came through his farm one day. His neighbors came to console him, and when he was asked about his misfortune, he said only, "Good luck, bad luck: who knows?" A few days later, his horse returned and brought some of the wild horses with him. Now the farmer had many horses, and the neighbors came back proclaiming his good luck, but the farmer only muttered, "Good luck, bad luck: who knows." His only son then tried to break one of the wild horses and was thrown off and broke his leg. The neighbors came and offered their condolences for his son's bad luck, and the farmer again, said, "Good luck, bad luck: who knows." A war broke out, and the local militia came to conscript all the able bodied young men of the village. Because the farmer's son had a broken leg, he was passed over for conscription. Again, the neighbors came and said their piece, and the farmer only said, "Good luck, bad luck: who knows." I have told this story many times over the years, and everyone, at some level, understands its truth. The only constant to life is change. In January the Fed said the rate hikes were nearing an end. As a result, the market rallied almost 1,000 points over the next few months. Fed Chairman Ben Bernanke was asked if the market had it right? He said no, and within 30 days the 1,000 points had disappeared. After the most recent Fed rate hike, the language softened and the market again began to rally. Then, Israel and Hezbollah started hurling bombs at each other, and the market gave up most of what it had gained again. What is the lesson here? There are several: Today's hot news won't last; good news will not likely grow to heaven; bad news does not always destroy us; Ben Bernanke is a bit green in his public pronouncements; Ben Bernanke is doing as good a job as anyone could do under the circumstances; maybe the news of the days and the stock market's gyration on most days is just noise. The important thing to remember is that these are not unusual times. History shows us again and again that the news and the markets are always doing the tango. Every great investor that I have ever studied has said the same thing. The single most important investment precept is to buy companies that can stand the test of time. Why, because in time, every company will be tested. Good luck and bad luck will befall every company, and either kind of luck can destroy a company that is not equipped for change. The second most important precept is to buy companies that are valuable and undervalued. Warren Buffett says to buy great companies at good to great prices. Mr. Buffett does not say what he means by good to great prices, but he gives the clear indication that when prices are "good to great" for a company the investment world will probably be "down" on its prospects. Another way of saying this is that the company will be going through a time of testing, and investors are betting that the company won't make it this time. I believe I have heard Mr. Buffett say, that he looks more at the companies hitting new yearly lows than at the companies hitting new annual highs. I attribute the third precept primarily to John Templeton, the founder of the Templeton Funds. Mr. Templeton spoke often of acting on the courage of your conviction. He also spoke of the concept of maximum pessimism. J. Paul Getty and Ben Graham also echo these sentiments. To stick with the courage of your convictions, even in the face of a run of bad luck. This is not to say that Mr. Templeton advocates relying on blind luck; it is to say that if the companies you own have proven in the past that they can stand the test of time, do not abandon them in their time of testing. One day their luck will change, and the investment world will take note of it and drive their price to the moon. The sages of the investment pantheon all agree that you must have some means of determining the probable value of a company or the market. Without that, most people cannot stand bad luck very long. If you know the probable value of a company, bad luck is almost a cause for celebration because you know that the investors who invest only in prices will be selling and good to great prices may be just around the corner. Fed Chairman, Ben Bernanke, spoke today, and tomorrow the financial media will all say that he had some "good news" in his speech and that was the reason that stocks rocketed over 200 points higher, even though rockets of another sort are still flying in the Middle East. My belief is simple, and the same as I have been saying for months: sooner or later the Fed is going to stop their rate hikes, and when they do, investors will find that many stocks are too cheap and rush to push them higher, as they did today. Our valuation models suggest that the average stock in our Rising Dividend Strategy is 15% underpriced. The story of the old farmer has no ending. Good luck and bad luck will come to everyone, but if we let the world define when we should zig and when we should zag, there is a good chance of mistaking one for the other. The masters say that investing is not a function of zigging and zagging, but of zeroing in on companies that can fly in either kind of weather