I’ve been traveling for the last two weeks, and thus the reason for the lack of posts. But I’ve been working and reading as usual, and actually have been active in making a few investments, despite the overall market climbing to new highs. I’ve mentioned this before, but it’s worth saying again… I put almost no emphasis on what the overall market is doing and where the indices are. I simply look for undervalued stocks.
But regardless of the methods involved in making investments, with a rising market comes rising risk. One of the ways I choose to lower my risk is by simply looking for depressed prices. As readers of this blog know, I love simplistic and basic thinking. One of the basic ways to think about stock prices is:
When stock prices rise, risk rises. Conversely, when they fall, risk falls.
This obviously assumes all other fundamentals remain constant, which isn’t always true, but on a day to day basis, it generally is.
Where Are The Values?
So if rising stock prices raise risk, then it would be natural to want to look where stock prices are going down, and thus lowering investment risk. This is probably why many value managers like to look at the 52-week low list. I like this list too, but there are other lists I like better, such as the stocks that have fallen the most in the last month, quarter, or year. One of my favorite ways to gauge sentiment is by looking at Value Line’s list of 98 industries that they rank each week. Momentum exists, and so many of these cheap stocks get cheaper. But one thing I’ve learned about market anomalies: Mean reversion almost always beats momentum in the long run, especially when you’re considering momentum on the downside.
Taking a quick scan of any of these lists, you’ll notice many stocks in the metals and mining industries keep showing up. Precious metals is one of the worst ranked industries in Value Line, and many gold and silver mining stocks have lost 50% to 75% of their value in the last 6 months alone.
Look to the Balance Sheet First for Risk Management
I’m very much a Graham and Dodd investor, so I like to look at balance sheet first and foremost. My favorite investor is Walter Schloss, and he too studied the balance sheet first. I think the reason for this was not that the balance sheet provided better insight into the potential for investment profits, but that the balance sheet provided a better view of the risk of the stock. One of the key things I learned from studying Schloss is that one of the best ways to reduce risk is to own businesses with low debt and good liquidity.
This is especially true when looking at stocks on new low lists. Many of these stocks are bad businesses, and many will go bankrupt if they are not adequately capitalized.
So when looking at new low lists or other basic value lists, look for stocks with low debt to equity ratios and high current ratios (current assets less current liabilities: a back of the envelope way to judge liquidity, i.e. how likely a business is to be able to adequately meet its short term obligations to stay in business).
Herd Behavior Causes General Mispricing: Be Contrarian
When the majority doesn’t like a stock or a group of stocks, these stocks tend to get mispriced. It goes back to the Greenblatt Magic Formula idea that some of these stocks will go down, some will go up, but on balance, you can own a group of stocks that provide good odds of outperforming.
The basic logic is that the stocks have all priced in the current bad news and poor business environments. If the bad news materializes, that is what is expected, so you hypothetically won’t lose much. If any bit of good news occurs, or if the business improves or industry fundamentals turn around, or if there is any positive surprise, the stock can have significant upside.
So on balance, you can build a portfolio that has an average risk reward ratio that is asymmetrically skewed to the upside. Graham likened owning a group of undervalued securities to the insurance underwriting business… in a life insurance portfolio of 1000 lives, there will likely be 6 or 8 unexpected deaths that will cost the insurance company in a death claim. The company obviously doesn’t know in advance who the unfortunate people will be, but they know that with proper underwriting, they will achieve profits on the overall portfolio of lives.
In investing, the idea is that some stocks will be losers, but on balance, the winners more than compensate for the losers. This philosophy is how Walter Schloss made 21% per year for nearly 50 years.
Quick Comment on Graham/Schloss vs Buffett Philosophy
Graham and Schloss ran their portfolios much differently than Buffett and many of the other talented investors of today. The two key differences were that Graham and Schloss chose to be diversified and they allowed themselves to own businesses without competitive advantages. The latter is probably the reason for the former. Unlike Buffett, who wants his margin of safety in large part through the quality of the business, Graham and Schloss wanted their margins of safety through the valuations of the business. They wanted to own cheap stocks. But they took their margin of safety concept one step further… they didn’t just want cheap stocks, they wanted a lot of cheap stocks. So they established their safety margins through the individual securities, and also through diversification at the portfolio level.
I’ve talked about these differences before between Buffett and Graham, and why I think most individual investors would benefit by adopting a philosophy closer to Graham. It’s a very interesting topic to consider. But value investors come in all different variations, and there are many talented Buffett style investors to learn from.
Buffett wouldn’t own many of the stocks I’m currently looking at. One group that many value investors eschew is the precious metals industry. Buffett wouldn’t own gold stocks. I can’t really blame him. They have no competitive advantages. They are tied to a commodity that is basically impossible to price intrinsically. But Schloss did own some gold stocks, commodity stocks, and other capital intensive businesses.
He wasn’t the only one. Templeton did, Graham did, Neff did, and many other great investors did. It’s not that they liked the businesses, or the industries, or that they had portfolio allocation requirements, etc… it’s simply that they owned the stocks that were cheap. They didn’t care much about competitive advantages or long term business prospects. They assumed they were no better than the average professional in judging business prospects. So they chose to buy cheap stocks.
Later this week, I’ll discuss why I invested 5% of my portfolio into a basket of well financed gold and silver miners, and why I think that despite the difficulty in valuing the businesses, that a margin of safety exists and why I think there could be asymmetric returns on the upside. “Good things happen to cheap stocks”.