Stocks on the Cheap:

Over the past few months, before I even began liquidating my Value Portfolio, I began to sense an opportunity in the markets that I had waited a long time for since observing the declines of 2000-2002. Despite the perpetual pessimistic commentary being flooded into the media on this current crisis each investor needs to put this situation into the proper perspective. I’m not discounting the seriousness of present market conditions because they are real and investors are feeling the pain in their pockets. But what any investor needs to do is take stock in their financial situation and look beyond today towards tomorrow.

I’ve been speaking loudly through this blog for investors to properly examine their tolerance for risk. That’s not just important now in these market conditions, but at any point. We’re seeing a massive move on the part of many investors (retail & institutional) to liquidate investments in a hurried move to conserve equity and build cash. For right or wrong investors believe this is the prudent choice and I’m not here to tell anyone else what they should or shouldn’t do. What I can state clearly is that this behaviour is a direct result of investors not acknowledging their risk tolerance, not understanding what they were investing in or not even being aware of why those first two points are important.

Emotions, fear, panic & irrational decisions always create value and while this market decline might not be value in the eyes of many it certainly has caught my attention.

Relative Valuations:

The difficulty in assessing a market such as this is how to assess relative valuations of investments. The big cause for these declines is the loss of confidence between all parties for exposure to bad debt and credit obligations and a serious reassessment of risk. Large hedge funds have had to liquidate holdings in order to meet stricter lending requirements, investors are fearful of future financial failures and the contagion effect is evidently spreading to the rest of the equity markets and global economy. With the drastic fall of equity prices the subsequent price to earnings ratios (P/E) of many stocks has been reduced; in some cases by half or more.

For a specific company you own, research or want to invest in the question an investor needs to answer is: Do I anticipate operating earnings to remain stable, increase or decrease in the future?

If earnings are to decrease than you need to adjust both the current and forward P/E to reflect that change. A stock that has dropped from a P/E of 15 to 10 might appear to be good value, but if future earnings are to decrease 50% than the stock continues to trade at the same valuation. Another company with no expected change to earnings trading at a discount to its former P/E may just be suffering from a P/E contraction across the entire sector or could provide an investor with a much cheaper entry point than what you previously would have paid.

At this moment I view three types of valuations in the markets:

1. There are bad businesses that are expensive for a reason
2. There are decent businesses that are of fair value dependent on their future earnings
3. There are great businesses that are very cheap relative to stable and/or increasing earnings

Companies with focused management, strong pricing power and diversified products & services will have more flexibility to better position their earnings potential. When you examine the forward P/E you may want to focus on companies where the profit projections aren’t dependent on volatile commodity prices, hard to decipher revenues and expenses and management that accurately deliver earnings within +/-5% of their guidance. This will give you a reasonable expectation of where to expect earnings to fall inline so that you can appropriately value an investment on a P/E basis if you choose to. What I anticipate moving forward is a lot of earnings volatility. Whether analyst consensus is achieved or not I feel that investors should do their own due diligence to make sure they understand how much they’re paying.

Catch a Falling Knife:

I’ve patiently observed the markets the past few weeks trying to gain a sense of perceptions, fear, fundamentals and relative value of investments and I’ve come to a few conclusions.

There have been numerous investors, pundits and professionals making clear statements of where they perceive the bottom (or lack thereof) to be and a variety of individual investors attempting to time the market for the expected recovery. It could come in the form of a 10-20% move in only a few short days, market prices could stabilize and return 0% over a five year period or plunge even further from where we are right now. The fact is I cannot time the bottom in order to know where the best value will be and likely no one can. People will use volatility, rules, past periods or trends but it’s mostly garbage in my view because this decline is nothing like anyone has seen in recent memory both on scale and speed. Since I am not able to time the bottom of the market than I have a number of choices to choose from.

One extreme is to sell now, book a large loss and sit in cash hoping to ride out this storm by preserving all my remaining capital. The problem is that by sitting with only cash I will likely miss the first glimmer of upside which could be a year’s worth of gains in only one day. In cash I will be drawing dead if all I earn is 4%, inflation is at 3% and my interest income is taxed 100% at my marginal tax rate.

The other extreme is to commit everything I have to my long-term positions now and ride out the storm for however long it takes. I collect my dividends every quarter, which are tax advantaged, but potentially see my invested capital continue to fall with the declines of the market.

The best alternative is a strategy that allows me to stay invested in the market, but keeps cash on hand for further purchases over the short-term. This will allow me to dollar cost average into my existing positions, increase the relative proportion of my dividend income and best position myself for the long-term. Each time I invest into more shares of my existing positions I am buying at a lower cost. While over the short-term this might appear to be a pointless strategy what I am doing is buying more shares at cheaper valuations for the future. Because I am in the contribution stage of my investing life (adding to investments for retirement) and I have a long-term investing horizon (25+ years) I’m taking the stance that the shares I own today will be worth substantially more in the future. The capital that I invest today may be only 10% of the total worth of my ending portfolio at retirement, so I have to maintain the proper perspective and context. If this market decline continues for another month and markets stay low for the next year I can periodically add to my positions on weakness without committing everything I have in a massive market binge.

What I have right now is an investment strategy that I hold superior confidence in. I’ve researched my plan, evaluated all the potential outcomes and have the confidence that this is the best available option for me. Every investor should have a plan that they are comfortable with, that takes into consideration their current & future risk tolerance and what they can execute without needing to change time after time.

There is nothing wrong with the alternative of sitting in cash if you’re mind is a mix of extreme emotions on the markets. During 2000-2002 I sat and watched with interest as the market collapsed under the pressure of the technology bubble. I knew then that I wasn’t anywhere near ready to invest into individual equities despite the value that was present. What I did was take a proactive approach and stick to the plan I had implemented then and invested accordingly regardless of what else was going on. I took the time to research, watch and observe market behaviour, insights, commentary and any lessons I could learn. I developed the patience, discipline and independent thinking to help overcome the emotional response to losing money. It’s never easy watching an investment lose value and no one enjoys it, but it is a part of investing and the market cycle. The key is to remember when to take advantage of opportunities and when to protect yourself from risk.

If you’re unsure of how to do either of those, then you’re best to stick to a very simple investing plan like the couch potato portfolio. A lot of my friends currently utilize this indexing strategy and I’ve had numerous questions about how these market conditions might change that plan. Friends want to know whether to hold onto or invest cash or stop making regular contributions.

If your investing strategy is to build your investments over the long-term, then I would advocate staying the course. An investor may want to increase contributions in order to take advantage of lower prices, but what you don’t want to do is drastically change your strategy. As in my post last week an investor can always choose to alter their asset allocation in order to reduce risk. Instead of a 60/40 equity-bond mix you may elect for a 50/50 split. Even sticking to your asset allocation will benefit your portfolio over the long-term.

As your equity funds have lost value during these past few weeks later this year when you rebalance you’ll be taking gains from bonds into your other funds to rebalance. If you’re committed to the couch potato strategy you want to be buying more of your reduced funds (buy low) with proceeds from your increased funds (sell high) when you rebalance. Trying to rebalance in volatile periods is akin to micromanaging your portfolio. While it might seem like a good idea at the time committing yourself to rebalancing at set dates is likely a disciplined move. Stopping contributions right now defeats the inherent benefit of the potato strategy by not using the buy low, sell high principles. Just as you would sell index equity funds in years of market gains to buy bonds you should now be turning around the strategy to do the opposite.

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