Upside of the Down Dow


Upside of the Down Dow

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

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.


"It might be best," he writes, "for [the conservative investor] to concentrate on issues selling at a reasonably close approximation to their tangible-asset value -- say, at not more than one-third above that figure. Purchases made at such levels, or lower, may with logic be regarded as related to the company's balance sheet, and as having a justification or support independent of the fluctuating market prices.... The investor with a stock portfolio having such book values behind it...can give as little attention as he pleases to the vagaries of the stock market."

While he focuses on book value, Graham also highlights the importance of a satisfactory price-earnings ratio and "a sufficiently strong financial position" when identifying investments that can best weather market storms. This is part of the value investor's catechism: The best way to deal with a chaotic and unpredictable market is to own extremely undervalued stocks with strong balance sheets.

Today's market, while treacherous, offers the broadest range of significantly undervalued stocks that we've ever seen. It goes without saying that prudence is even more necessary than usual in such a market, but three basic strategies strike us as particularly compelling today.

The easiest is to let someone else do the heavy lifting for you. Warren Buffett's Berkshire Hathaway has committed nearly $50 billion of capital this year to new investments, on increasingly attractive terms. Berkshire shareholders will be well rewarded for years to come from recent purchases of Constellation Energy and investments in Goldman Sachs and General Electric, among others. Berkshire has one of the strongest balance sheets in the world and is growing at a healthy clip, and we believe its Class B shares (symbol BRK.B), trading in mid October at $3,780, are undervalued by more than 25%.


For those with stronger stomachs, some decimated energy stocks are also highly attractive. Speculative excess had crept into the sector as commodity prices hit record levels earlier this year. But that excess of optimism appears to have been replaced by an excess of fear, as concerns over weak demand have hurt energy prices. In addition, leveraged, momentum-driven investors have panicked, leading to an even more dramatic decline in energy shares.

Particularly attractive today, we believe, are natural-gas processing and pipeline companies, which have limited commodity-price risk and pay out nearly all of their earnings in hefty dividends. Investors can buy them via publicly traded master limited partnerships, such as Crosstex Energy LP (XTEX), one of our favorites. The stock had fallen nearly 56% in little more than a month to its mid-October price of about $10, where it yielded more than 25%. We think it's easily worth twice that $10 share price.

We always like to buy blue-chip companies in out-of-favor sectors when their stocks plummet, if (and this is a big if) they have balance sheets strong enough not only to weather the storm but to profit from it -- for example, by buying back their own stock or acquiring competitors.

We've been too early in buying shares of discount retailer Target (TGT). But as we wait for consumer spending to stabilize, the company continues to grow and buy back its stock at depressed levels. In a normal operating environment, we expect Target's shares to be worth more than double their mid-October price of $37. Even if "normal" doesn't return for another two to three years, that still provides an attractive potential return.

Finally, some truly vintage Ben Graham -- his core message: "Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies."

Timeless advice, indeed. A stock price matters at any given time only in relation to the value of the company behind it. Staying focused on value rather than price during times of market turmoil is most likely to pay financial (not to mention psychological) dividends.

Columnists Whitney Tilson and John Heins co-edit ValueInvestor Insight and SuperInvestor Insight. Funds co-managed by Tilson own shares in Berkshire Hathaway, Target and the parent company of Crosstex Energy LP.