Wednesday, November 19, 2008

Valuations Don't Matter - In the Short Run

The markets are going through a historic transformation. During this process, all rationality goes out the window. Consider what happened to the tripling in price of credit swaps covering Berkshire Hathaway for a bet they made that doesn't come due until 2019.

Valuations today simply mean the short run. "Cheap" has taken on a whole new meaning. And if your business has any amount of meaningful debt, the market hates you even more.

Without a doubt the excessive decline in share prices has been exacerbated by the forced selling--from everyone. Mutual fund redemption's are at an all time high. Pension funds are getting hit. And of course, our hedge fund brethren who decided to buy $15 dollars worth of stock for every dollar handed to them by investors.

I echo Buffett's sentiments that years from now, certain businesses will be earning record profits. Nonetheless, while it's a fools game to attempt to call a bottom, certain things must occur before the environment truly gets better going forward. Mr. Market is confused and it's absurd to see nearly 1,000 point swings in a single day. At this point, a stable 1,000 advance in the market over the course of year would represent over a 12% return - something that every investor would take solace in.

While we value investors prefer to concentrate our efforts in our very best ideas, I think one will do exceedingly well in today's market by buying a less concentrated basket of excellent securities that are trading at magnificent discounts to their true value. Many large-cap companies today are trading at absurd valuations even when you normalize earnings over multi-year periods. ConocoPhillips is absurdly cheap and makes money even when oil is at $50. American Express is another.

Joel Greenblatt has done just this by simply buying hundreds of his Magic Formula stocks and going away. The irony in investing is that as markets tank and performance declines, it's easier to invest going forward. Starting point matters. An amateur investor picking a basket of low P/E, strong balance sheet stocks today will likely produce better numbers over the next year or two than many seasoned pros. This merely a function of getting in at a much lower starting point.

While the re-capitalization of the big financial firms was a big step in the right direction (whether you agree with the actual plan or not, no plan at all would have caused unthinkable consequences), we still need to see:

1. Stabilizing Housing Prices - It's amazing that homebuilders still continue to pump out new houses and even more amazing that no homebuilder has gone under. Supply of new homes need to cease.

2. Resumption of corporate M&A Activity - companies need to start taking their cash and putting it to work. When this happens, everyone on the sideline will take notice.

Now is not the time to be losing faith, but I wouldn't expect much in the short run. Investors could be down another 10% to 15% before finally being vindicated.

1 comment:

Anonymous said...


You have nailed couple of nice points.
1. Bill Miller once said that concentration is good when valuations are low selectively. But in an environment where valuation is low across the entire market, it is wise to diversify b/c the benefits of concentration become less mangnified in this environment. Diversification provides similar upside with lower stock specific risk in this environment.

2. I think the reduced valuation is combination of fundamental plus noise related issues. The noise is those that you captured like mutual fund redemptions, Hedge fund forced selling etc.

3. The fundamental issue of housing will eventually take care of itself. But I think it is unlikely financial institutions will go back to loose lending to consumers (credit cards, refinance or Home equity line) like before even after credit crunch is resolved. This means that consumer needs to tighten belt which will impact GDP and the company. This will not go away soon. So it is correct to state that intrinsic value of companies as a whole is reduced from prior levels but likely the market's reaction is more than that. So appreciation potential is good from this level since market has discounted a lot unless it turns out to be great depression.