Stand By Your Stocks

Although the economy's prospects appear awful, share prices already reflect a severe downturn.

By Whitney Tilson, Contributing Editor

John Heins, Contributing Editor

From Kiplinger's Personal Finance magazine, May 2009

Had you asked us a year ago how much attention we pay to the economic big picture, our answer would have been, "Not very much." Given how difficult it is even for experts to accurately forecast such things as economic growth, inflation and interest rates, we have always felt our time was better spent analyzing specific businesses and stocks.

One lesson of the recent past, however, is that powerful economic forces can render meaningless even the most astute company analysis. In fact, you could argue that over the past year the only thing that determined performance was how you bet on major economic trends. This situation is unlikely to change, at least not in the near term.

Rare occurrence. Other than agreeing with the consensus that the economy's prospects appear awful, we don't profess to have unique insight into such big-picture matters. That said, we believe share prices already reflect a severe downturn -- call it the Great Recession. The Dow industrials hit a 12-year low in early March. Only twice before, on April 8, 1932, and December 6, 1974, has the Dow been lower than it was 12 years earlier. In both prior cases, the economy and the jobless rate were still months away from their worst readings, yet stocks rose over the following six months -- by 5% and 45%, respectively.

Stocks are certainly cheap. Based on data from Yale economist Robert Shiller, U.S. stocks in early March traded at a cyclical price-earnings ratio of about 12, their lowest level since 1986 and well below their historical average, dating back to 1870, of 16.3. (The cyclical P/E seeks to smooth out the effects of booms and busts by using average earnings over the previous ten years.) Whenever P/Es have dropped to similar levels over the past 125 years, stocks have doubled, on average, over the next decade.

What's an investor to do in such a perilous but potentially opportunity-filled environment? One approach is to avoid stocks entirely until the economy stabilizes and share prices start to recover. Seth Klarman, president of Baupost Group and one of the most successful value managers of our generation, addresses this question in his latest annual letter: "While it is always tempting to try to time the market and wait for the bottom to be reached (as if it would be obvious when it arrived), such a strategy has proven over the years to be deeply flawed. Historically ... competition from other buyers will be much greater when the markets settle down and the economy begins to recover. Moreover, the price recovery from a bottom can be very swift."

We agree, although we by no means suggest throwing caution to the wind. We recommend owning more stocks than usual. We also suggest selling some stocks short to hedge the risk of a further market decline. With our long positions, we're focusing on stocks that are trading at multiyear lows -- not because of any permanent impairment in the companies' competitive positions, but rather because of overall market declines. Among large companies in this category are American Express (symbol AXP), Berkshire Hathaway (BRK-B) and Target (TGT).

We also like some companies in the midst of turnarounds. The success of these picks rests more on how well the firms execute their revival plans than on the course of the overall economy. Two examples: fast-food chain Wendy's/Arby's Group (WEN) and grocer Winn-Dixie Stores (WINN).

The range of potential outcomes -- for the economy and for individual companies -- is as wide today as we've ever seen. Jeremy Grantham, of investment manager GMO, described this state of affairs recently in an interview with Value Investor Insight (which we co-edit): "The probabilities of things we're looking at today are 60/40 or 55/45." In other words, there are few sure things. That's something to keep top-of-mind in a market like the one we're experiencing today.

Columnists Whitney Tilson and John Heins co-edit ValueInvestor Insight and SuperInvestor Insight. Funds co-managed by Tilson own shares of Johnson & Johnson and Coca-Cola.

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