Markets

Upside of the Down Dow

Today's market offers the broadest range of undervalued stocks that we've ever seen.

By Whitney Tilson, Contributing Editor

John Heins, Contributing Editor

From Kiplinger's Personal Finance magazine, December 2008

Dispensing investing advice is difficult enough in normal times. It becomes particularly tricky when markets behave chaotically, as they have in recent months.

In early October, Warren Buffett called the current market turmoil unprecedented in his investment lifetime, which spans more than 50 years. So what appears to make sense one day under a given set of assumptions can become obsolete a week later when the behavior of the market (or of Washington, as the case may be) throws those assumptions out the window.

The intelligent investor

But certain investment wisdom is timeless. It deserves to be revisited for inspiration and information -- or just as a sanity check when the investment world appears to be somewhat less than sane.

At the top of that list is the eighth chapter of Benjamin Graham's The Intelligent Investor, in which the patron saint of value investing explores how market fluctuations can, and should, impact investment decisions. Buffett has called this chapter, along with Chapter 20 on margin of safety in the same book, "the two most important essays ever written on investing." In light of the market's recent behavior, now appears to be an excellent time for a Graham refresher course:

"Since common stocks, even of investment grade, are subject to recurrent and wide fluctuations in their prices," Graham wrote, "the intelligent investor should be interested in the possibilities of profiting from these pendulum swings.... He should always remember that market quotations are there for his convenience, either to be taken advantage of or to be ignored."

Graham makes a distinction between trying to profit by "timing" and by "pricing." He likens making bets on the anticipated direction of the overall market (timing) to speculative folly, providing "a speculator's financial results." The true opportunity presented by volatility, he writes, is simply to take advantage of the resulting price changes "to buy stocks when they are quoted below their fair value" and to sell them when they rise above that value. Graham adds:

"The investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons' mistakes of judgment."

The "basic advantage" to which Graham refers is your freedom as an individual investor to ignore Mr. Market's whims -- a luxury not always enjoyed by professionals dealing with cash inflows and outflows or obsessively focused on perform-ance compared against some benchmark.

Jason Zweig, whose commentary accompanies the revised edition of Graham's book, blames the media for contributing to the "mental anguish" that falling stock prices cause. Breathless TV reporters and newspaper headlines depicting a 200-point fall in the Dow Jones industrial average as a "plunge," for example, feed investor anxiety beyond what has actually transpired.

This is not to say you should stick your head in the sand as stocks in your portfolio decline. In fact, when share prices fall more rapidly than any change you perceive in business value, you should be looking to take advantage of that and buy.

More from Graham

The "market often goes far wrong, and sometimes an alert and courageous investor can take advantage of its patent errors.... Most businesses change in character and quality over the years, sometimes for the better, perhaps more often for the worse. The investor need not watch his companies' performance like a hawk; but he should give it a good, hard look from time to time."

Graham recounts the wide swings in investor sentiment toward once-venerable grocer A&P -- often at considerable odds with the company's actual performance, which deteriorated considerably by the early 1970s. His caution against complacency in monitoring the business and competitive dynamics at portfolio companies -- given at a time when competitive dynamics changed more slowly than they do today -- is more relevant now than ever.

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