Staying in the Game

This recent note, from a friend who is a wise and experienced individual investor, captures well the mood of today's shellshocked market participant:

"In my smaller and smaller trading account, I try to bottom-fish, but the bottom keeps moving lower and lower. For instance, I own coal company Massey Energy, which has already locked in sales of substantially all its 2009 production and some of its 2010 production, yet it trades at two times Merrill Lynch's 2009 earnings estimate. I keep buying shares, and it keeps getting beaten down beyond the point of absurd-ity. So what's the point of staying in this game?"

Our friend's thought process illustrates much of what Oaktree Capital Management chairman Howard Marks has described as the three stages of a bear market. In the first stage, just a few prudent investors recognize that the still-prevailing bullishness is likely to be unfounded, he says. In the second stage, the market drifts down in an orderly fashion. By the third stage, everyone is convinced things can only get worse, volatility increases sharply, and the collective herd exits.

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The bottom?

Marks has pegged October -- during which the broad-based Russell 3000 index tumbled 18% -- as the point at which the current bear market entered its third phase. As he said at the time: "That doesn't mean [the market] can't decline further, or that a bull market's about to start. But it does mean the negatives are on the table, optimism is thoroughly lacking, and the greater long-term risk probably lies in not investing."

There is plenty of historical support for the notion that the risk-reward ratio has, in fact, shifted in favor of being invested rather than not being invested. Ibbotson Associates, a Morningstar company, recently calculated over time the rolling ten-year annualized returns generated by Standard & Poor's 500-stock index. Before last October, at only one point in history, 1938, had the previous ten years generated a negative compound annual return in the S&P 500. Whenever ten-year returns even approached 0%, the market moved dramatically higher over the next ten years.

That's all well and good, a skeptic might say, but haven't you noticed what's going on out there? Namely, we're more than 12 months into a recession -- already longer than all but two of the ten recessions the U.S. has endured since World War II -- and there's considerable evidence that the economic pain sharply accelerated in 2008's fourth quarter, boding ill for 2009.

No argument there, but the near-term economy shouldn't be the main driver of any stock-buying decision today. That's because it's so difficult to assess how that economic state will actually translate into stock prices. As Warren Buffett put it in a New York Times essay last October: "I haven't the faintest idea as to whether stocks will be higher or lower a month -- or a year -- from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over."

Babies and bath water

Another impetus for potential bargain hunters is the indiscriminate selling during this decline. Global-equity strategist James Montier, of France's Société Générale, found that 98% of all stocks in the U.S. and Europe have delivered negative returns in 2008. He also broke individual stocks into deciles based on relative valuation -- from "value" to "glamour" -- and found that no decile category had suffered an average decline of less than 40%.

It's when the proverbial babies are thrown out with the bath water that opportunities are frequently born. Value investor Seth Klarman of the Baupost Group recently put it a slightly different way for his investors: "The chaos is so extreme, the panic selling so urgent, that there is almost no possibility that sellers are acting on superior infor-mation. Indeed, in situation after situation, it seems clear that investment fundamentals do not factor into their decision-making at all."

When short-term indiscriminate selling is driving share prices, we've found the best place to look for bargains is in what we already own. Here's the latest on three of our favorites.

In two weeks in November, Berkshire Hathaway Class B shares (symbol BRK-B) plunged nearly 40%, from about $4,000 to an intraday low of $2,450 on absurd rumors that derivative contracts the company had written -- expiring in more than 13 years, on average -- would saddle the company with big losses and possibly even trigger a liquidity crunch. Some sanity has returned, but at about $3,400 in early December, the shares are still significantly undervalued.

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We estimate Berkshire's valuation the same way Buffett does, by valuing the company's investments (cash, bonds and stocks) at market and then placing a multiple of 12 on the pretax operating profits of the company. With estimated pretax earnings of nearly $170 per Class B share and investments currently valued at about $2,500 per share, we believe that shares of Berkshire are worth at least $4,500.

Early in 2008, EchoStar Holding Corp. anticipated that its Dish Network might attract the eye of a major telecommunications firm. So it spun off assets the company owned that might not be attractive to such a suitor (primarily a network of satellites and a business that manufactures converter boxes for TVs) into a new company called Echo-Star (SATS).

The new EchoStar's shares have fallen nearly 60% since they started trading a year ago. At $14 in early December, the share price translates into a market value of about $1.3 billion. As the company currently has cash, marketable securities and net trade receivables from its former parent company of roughly the same amount, it means that at today's price, you're able to buy a network of nine owned or leased satellites and the converter-box business essentially for free. The new company generates roughly $1.5 billion in revenues, mostly from Dish Network.

Based on the market values of comparable assets, we believe the satellite network is worth about $800 million. The converter-box business, which has the potential to expand significantly now that it can sell its wares to Dish Network's competitors as well, is likely worth at least the overall company's current market value of about $1.3 billion. Add it all up, and we believe the stock is worth at least the $35 per share at which it started trading a year ago. Given the nonoperating marketable assets, there's a big and welcome margin of safety as we wait for the underlying value to be realized.

Following the merger of fast-food chain Wendy's with Triarc Cos., owner of Arby's, the newly named Wendy's/Arby's Group (WEN) is now being run by Triarc's Nelson Peltz and his team. Peltz's team are top operators who engineered a remarkable turnaround at Arby's, and they are a good bet, we believe, to do the same with Wendy's.

At Arby's -- which faced more challenges than Wendy's -- Peltz and his team cut costs and refranchised company-owned restaurants, a highly successful game plan that should serve Wendy's well. At a recent $3.88, Wendy's shares trade for a rock-bottom four times the ratio of the company's enterprise value -- stock-market capitalization plus net debt -- to earnings before interest, taxes, depreciation and amortization. As the business is revamped, we believe the shares have the potential to double.

Peltz, the new company's largest shareholder, certainly thinks Wendy's is undervalued -- so much so that he has a tender offer in the market right now to buy 10% of the outstanding shares for $4.15, 7% higher than today's market price.

The murky future

Back in 1979, during a period in which institutional and individual investors alike were gun-shy about stocks (sound familiar?), Forbes asked Warren Buffett for his views on dealing with uncertainty. His reply:

"An argument is made that there are just too many question marks about the near future; wouldn't it be better to wait until things clear up a bit? You know the prose: 'Maintain buying reserves until current uncertainties are resolved,' etc. Before reaching for that crutch, face up to two unpleasant facts: The future is never clear, and you pay a very high price for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values."

It's no easy task to maintain such a long-term perspective in the face of what appears to be the market's darkest hour. Of course, that's precisely when it's most necessary -- and most likely to pay off in future returns.

Columnists Whitney Tilson and John Heins co-edit ValueInvestor Insight and SuperInvestor Insight.