Monday, June 09, 2008

The Thing Most of Us Fear is in the Rear View Mirror

I read this weekend where many investors are "throwing in the towel" on stocks because they can't stand the ride. That is simply not a wise approach. As Warren Buffett once said, volatility does not equal risk. Volatile stocks feel risky, but that is just traders batting the stocks back and forth like tennis balls. They have a right to do this and, yes it would be "nice" if they would stay out of things, but that is not the way of the world. Volatility is here to stay, therefore, we must continue to refine and improve our valuation models to offer our clients "valuation information" that honestly quantifies the intrinsic value of a company, no matter how many tennis balls are flying about. Alan Greenspan said something in an interview recently that has stuck with me. He said that he had learned over the years that when bad things happen, the markets invariably freeze up with fear, and when good things happen, the markets explode with greed (Not exactly his words but close). He said this overzealous reaction in both directions appears to be innate. That would mean that even the most seasoned veteran traders, if they feel threatened, will cut and run, and this cut and run reaction promulgates further cut and run reactions among other traders, who pass it on to still yet other, ostensibly, rational souls, and so forth. Likewise when the news is good, a load-the-wagons mentality promulgates more loading of the wagon, which means more and more people become loaders of wagons. But knowing this, wouldn't it be smart for us long-term investors to cut and run early and avoid the rush when we see a cut and run mentality forming? Likewise when we sense a load-the-wagons mentality on the rise, shouldn't we load like crazy? If we were blessed with perfect timing, yes, but we are not and our own research and experience suggest that probably 95% of all cut and run news turns back on itself within the next 12 months, as does load-the-wagons news. Indeed, John Neff, of Windsor Mutual Funds fame, said that the best place to look for solid stocks to buy was on the list of stocks hitting new 52 week lows. Mr. Neff's words echo almost every famous investor who has ever lived -- buy low and sell high. Mr. Greenspan's thesis, however, is that buying low is innately difficult if not impossible for most investors, because it means buying that which appears to be heading down the tubes precisely at a time when their most powerful emotion is to cut and run. This is what we believe: Over a three to five year time frame, the value and price of a stock will reach a kind of fair value, or equilibrium. The rest of the time prices and values will weave and wobble around each other without any apparent tight correlation. Although we can find very high correlations between dividends and prices among many companies, our Dividend Valuation Tools are not infallible. They only work if a company is reasonably the same company over the next year or so that it has been over the last 20 years. The model requires very mortal men and women to interpret in 360 degrees what it really says about the true valuation of a company. Having said this, if we diversify our portfolios among 30 odd (uniquely wonderful) companies, we should be able to minimize the risk of any one company coming apart and sinking the whole portfolio. That is indeed what we have seen in the last year. Most of our banks have taken a knock. We had to sell Wachovia because they cut their dividend. We have spent more time in the last year analyzing accounting statements than all of us did in all the years we spent in accounting classes in college. On the other hand, our oil stocks, for obvious reasons, have had a sensational year. We have only slightly fewer oil stocks as a percentage of the portfolio than we have bank stocks. That sure makes sense, doesn't it? We have an oil crisis why not buy up the oil stocks. Well, we started buying almost all our of oil stocks in 2001, when the US was under a siege mentality and none of us were ever going to travel more than 20 miles from home for fear the terrorists would strike our home town. We bought oil when it seemed like the worst investment on earth. We bought oil because our models said: Oil is cheap, buy oil. We bought oil and figured about all we could expect for awhile was the dividend, but we bought oil because our models said oil stocks were very cheap. Oil stocks are not so cheap now. Indeed, oil stocks are dear now. Everyone on the face of the earth knows that oil will never fall in price. It can only go to $150 per p/b on its way to $200 p/b and whatever number you want to pick next. But isn't that the kind of "load-the-wagons" mentality that has lied to you and stolen from you all of your lives? When are we going to wise up and come to the conclusion that life is going on, somehow, someway. Life is going on, high oil prices or not. Economic growth is going to continue in every country in the world where men and women get to keep the majority of what they earn. You want to say it is different this time; it's really bad out there. Sure it is; but the opportunities that will come to those who have faith in the ingenuity, innovation, and work ethic of mankind will reap a bounty you cannot imagine over the next few years. The current subprime crisis will be only a memory just a few short years from now, and in the meantime, many companies, financial and otherwise, will prosper. If the managements of these companies are like many of American and World CEOs they will share their good fortune with their shareholders in the form of dividends. The steady growth of these dividends will propel many stocks higher, and one day, not as far down the road as you might think, the load-the -wagon crew will be buying bank stocks. They'll be saying things like: "Gotta have those global bank stocks. That's the thing that cannot lose. You know the world is shrinking and the language of finance is the most common language in the world." Many of you will find this soliloquy naively optimistic or simply devoid of reason. Others of you will not understand a word I have said here. But there will be a few -- a remnant -- a small collection of you who will say,
  • "You know that guy has been in the business for 33 years. He has seen the oil crisis of 1973-80, the high inflation and grinding unemployment of that time, Watergate, the Carter gas lines, the Reagan Revolution, the Iraq invasion of Kuwait, the collapse of the Soviet Union, the S&L crisis, Russia's default on it loans, the Tech wreck, the attempt to impeach a President, 9/11, the Enron scandal, Katrina, the Iraq war, the collapse of the dollar, and now oil at $135 per barrel. He says it is not different this time; that all these past crises proved only bumps in the road, and that progress continued after a period of acclimation or healing in every case; and to sell the world economy or the US economy short has been a terrible bet over the last 30 odd years. Furthermore, he says that it will continue to be a terrible bet as long as people are free and own the fruits of their own labor.

I don't know how or when the current crisis will be resolved, but I am confident that it will pass and that blessings will return. I do know that if we are patient, trust in long-term investing and the power of dividends, and not get caught up in the stuff of cut and run or how much we can pile on the wagon, that there will come a day when prices will intersect with values, which our models now say are about 25% lower than the current value of the average stock.

A Caveat: These are my opinions. Do not take them at face value. Go back and read about each of the crises I have mention here. See the headlines. See what the Wall Street Journal or the New York Times said. See if they were correct on anything and where they were wrong. Finally, see if you can determine how the crises was resolved; how things moved on.

I am basing my optimistic view of the future on my experience of a long series of crises in the past that somehow, someway got worked out. If we have entered a time where mankind cannot solve the problems of our own making, then my view is silly. But if the future looks anything like the past, we humans will figure out what went wrong, correct it, and move on.

Look at the list of crises I have listed; try to recall how you felt during as many of these times as you can. I think you will discover that Alan Greenspan was right: you felt very down and did not know how things could ever get better. Now look at them again and see if you can recall how each crises was resolved. Who were the players? Who helped us understand that doom and gloom were not the only attitudes permissible under the circumstances?