Greece is on the verge of almost certain default. Ireland and Portugal are not far behind. Contagion could spread to Italy and Spain, two of the largest economies in the EU, with $2 trillion and $1.4 trillion in nominal output respectively. Collateral damage could spread to the US, Asia, and Latin America, tipping the world into another severe recession.
A good time to stay in stocks — or buy more? Absolutely.
VALUE vs. NEWS
As Bill Nygren of the Oakmark Value Fund likes to say, people pay too much attention to the news, and too little attention to value. The news is fleeting, mercurial and impossible to predict. Value endures. The value investor’s secret — often referred to as “time arbitrage” — is the ability to take advantage of the normal human myopic fixation on the short-term to remain invested in stocks (or buy more) – with the reasonable belief that once fear dissipates, those prices will rise dramatically.
Are there downsides to such a value approach? Yes. For one, value takes time to be recognized, so it’s only for those who have time horizons of at least 3-5 years. It’s not for those focused on monthly returns or getting rich quick. The value investor forsakes any rights to the fast, blockbuster trade. But they do so knowing that traders come and go, with yesterday’s hero becoming tomorrow’s bankruptcy — while value investors have the best chance of making money over long periods of time.
As to the debacle that is now Europe, most equities have already priced in vicious scenarios. Worldwide, stocks are trading at between 8-12 times earnings, and 3-6 times operating cash flows. Stocks do not trade at such low levels unless they expect the worst. Even if earnings tilt downward in the wake of a new recession, price to earnings multiples are very, very cheap – especially relative to the interest rate backdrop to which they must be compared.
I often ask people: if you will not stay in stocks at 8-12 times earnings, at what price would you? Given that stocks never trade much below 7 times earnings, it seems like a fair question. After all, the idea is to buy low and sell high, not the other way around. Often, the reply is: “Yes, but don’t you read the papers, don’t you see what’s going on in the world?” What’s often forgotten is that stocks only trade at 8-12 times earnings when the macro outlook is truly miserable. That’s exactly why they trade at such a bargain. They never trade at 8-12 times earnings when things look rosy. As Buffett likes to say, “you pay a dear price for a cheery consensus.” Traders who try to catch the precise bottom often miss it completely, because stocks price in recovery well in advance of the actual economic realities. By the time it “it feels safe,” the market has already risen a few thousand points.
In March of 2009, with the Dow at 6,547, I posted a letter strongly advocating stocks on the Huffington Post. It didn’t really feel safe to buy stocks again until early 2011 when the market had nearly doubled to 12,800.
THIS TIME IS DIFFERENT?
At the best points in history to buy stocks, such as 1932, 1974, 2009 — and the present — the macro outlook was (and is) always gruesome. In 1932, when you could have picked up any company for a song, you would have been forgiven for being dissuaded by: 25% unemployment, the Dust Bowl, soup lines and Hoovervilles, thousands of banks shuttered with no deposit insurance, the impending collapse of the worldwide economy and a depression unparalleled in the human imagination. In 1974, when you also could have bought companies worth a dollar for a dime, you would have had to look past Watergate, the oil embargo, war in the Middle East, the Vietnam War, double-digit inflation, high unemployment, and an economy mired in a fresh form of hell called stagflation. Staying invested at either point (without trying to time the upturn) would have more than doubled your money over the next five years.
Often people kick themselves and ask things like: “Why didn’t I buy McDonald’s in 1974? I missed out on a 14,765% return (not a typo).” Or they ask: “Why didn’t I buy that apartment in NYC in 1975, when a 3-bedroom pre-war was selling for $80,000?” The answer is that it seemed terrifying at the time, given the macro turmoil. But decades later, the fear is long forgotten – and they are left to scold themselves and wonder: why? In 1974, the NYC apartment was cheap because NYC looked like it was going bust.
At the time, the fear justifies inaction because the fact pattern feels slightly different — different enough, in fact, to wonder if things could never get better again. It’s often said that the four most dangerous words in the investment world are: This time is different. This phrase is used to justify staying sidelined in cash during bad times when stocks are cheap. On the flip side, those words were used to justify staying invested in overvalued internet stocks in 1999 when pundits claimed valuation no longer mattered. Just as they do today.
It’s appealing for humans to feel they live in the very best or worst of times – a time unique. In periods of excessive optimism, the uniqueness gilds the lily of euphoria. In tough times, uniqueness imparts meaning to suffering. The reality is that no period in history is unique. Everything happening today has happened before – if in a slightly different pattern. As Mark Twain said: “History doesn’t repeat, but it rhymes.”
Today, we face high unemployment, another recession, a Euro debt crisis, unrest in the Middle East, and a political leadership in complete paralysis. Yet, much of this – if not all – is already priced into shares. The most cogent point made these days is that the political stewardship is poor, but it’s often poor at such points. In my valuation calculations, I always assume that politicians will not solve a single major problem. That is my way of discounting for political uncertainty. And still stocks look cheap in that context, because good companies will make more money in 5-10 years than they do today, no matter the politics. I do make one base assumption in buying equities: that the United States survives as a going concern. But it seems silly to invest with any alternative in mind. If true Armageddon arrives, and the U.S. devolves into dictatorship or complete anarchy, the only thing you’ll want to own is a shotgun. If you don’t share an overarching belief that this country will outlast yourself, then you should never invest in a single stock in the first place. But you also might consider moving to Canada or China.
Today, stocks are on sale. No one knows what the next year brings in markets, but history shows that stocks bought at these prices offer a satisfactory return over the next decade. Stocks may go lower still. They may go much lower tomorrow and the day after. None of that will change their expected positive return over the next decade – a return that is likely to beat cash and bonds by a wide margin. At dividend yields approaching 3%, stocks will return more than cash even if their prices go nowhere for ten years.
The attempt to catch the precise bottom or predict economic turns is a fool’s errand. Once you recognize real and compelling value, better to grab it. The trick is to recognize quality.
Picture yourself in NYC in the mid-1970’s: families are fleeing to the suburbs, the Bronx is burning, crime is approaching record highs, hypodermic needles litter the streets, Mayor Beame is on his way to the bankruptcy court steps, The Daily News proclaims: Ford to NYC: Drop Dead, a blackout leads to uncontrolled riots…but to the careful observer, there are signs of enduring quality: the new Lincoln Center has spawned a West Side recovery, the city remains the cultural and economic capital of the world and the World Trade Center has gone up as a testament to that reality.
Meanwhile, large pre-war apartment prices have collapsed and are selling for less than $40/sq foot, down from $60/sq foot in the late 1960’s. A very nice 2,000 square foot apartment is $80,000. Would you flee NYC? Or would you buy? Or would you fear that the $80,000 price tag would first drop to $70,000 and thus do nothing until the late 1990’s — when the NYC renaissance was finally obvious to all? The careful real estate investor does research and notices that certain neighborhoods are high quality but have been sold down in tandem with the general panic — that quality pre-war apartments are classics that will draw buyers eventually. And so the value investor sees opportunity where the general population sees only fear.
This is not Pollyanna. Guessing if the worst has passed just doesn’t work, because no one ever knows. Instead, the trick is to figure out if you’re in New York City or Flint, Michigan – admittedly not an easy task, but one within reach. I believe the United States and Europe are more like New York in the 1970’s: high quality chunks of extraordinary value facing enormous challenges — but selling at prices that well reflect those challenges. And stocks return much, much more than real estate from points of extreme value.
Today, if you look past the headlines and the myopia of euro-centered fear, you see blue chip multinationals trading for the lowest valuations in 60 years, with vast opportunities ahead of them in emerging economies like East Asia, Latin America and India. Even if their prices go 20% lower before doubling over the next 5-10 years, should it make a difference to those who can handle the wait?