Don't Succumb to Panic and Fear
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Two weeks ago, I attended the Value Investing Congress in New York City, and was fortunate to listen to quite a few very successful value investors. I also was able to meet speakers and other investors to learn more about their approach to investing in the current turbulent stock market. The experience was very enlightening, and I came away with some valuable insights that I want to pass along to you.
The Congress started with a detailed presentation about the recent history of mortgage lending and the events leading up to the financial crisis currently gripping the U.S. and many other countries. I could write several pages about the details presented, but I think I can simplify the events for you with the following summary: Consumers bought cars, homes and luxury items that they could not afford. Lenders provided loans with ridiculous terms. Wall Street invented highly leveraged securitized investments backed by mortgages and labeled them "high quality," even though they were very low quality. Regulators eased the rules and restrictions at a time when rules should have been tightened. The result was a perfect storm.
According to investors at the Congress, mortgage problems and home price declines will continue for quite some time. Only half of the adjustable rate mortgages have re-set to higher interest rates, which might indicate that the decline in home prices is only half over. The average home in America might decline a total of 30%. Home prices will likely move from an overvalued condition to undervalued.
The amount of time needed for the decline in home prices to run its course is anybody's guess. The consensus of opinion at the Congress was that another two to three years will be needed for the housing market and the economy to wash toxic mortgages through the system. Americans will need to adjust their spending habits to start saving more of their income, rather than spending more than their income. Banks will need to lend to consumers who can clearly afford to repay their debts. More regulation will be needed to meet the problems that new investment products can create.
What does all this mean for the stock market? As the economic and financial problems get worked out during the next few years, the stock market will continue to be volatile--hopefully not as volatile as the past few weeks, though. For value investors, it's now time to buy. The current low prices come along only once in a lifetime. Warren Buffett said it best: "Bad news is an investor's best friend. It lets you buy a slice of America's future at a marked-down price."
I learned a lot about how hedge fund managers consistently make money in the stock market at the Congress. We have all heard about how hedge fund managers leverage their investments and take high risks to produce extraordinary returns, but most of the investors at the Congress use a conservative value approach. Value hedge fund managers typically purchase large amounts of stock in a few small- to mid-size companies. They establish a personal rapport with management, gain a seat on the Board of Directors, and urge management to make changes that will make the company more successful and thereby increase the value of the stock. Value hedge fund managers make their investments with the objective of holding their stock positions for at least five years. It doesn't really matter if the company stumbles along during the first couple of years, as long as a solid long-term goal is achievable.
Small investors like you and me cannot take dominant positions in companies and then direct changes. So what do we do? Several speakers suggested that smaller investors should invest in high quality companies that are clearly undervalued and hold for at least three to five years. Eighty percent of the material reported on TV or in research reports pertains to company financial information and forecasts for the next three- to 12-month period. Another 10% of information pertains to two-year forecasts. The remaining 10% pertains to forecasts of more than two years. In other words, investors are concentrating heavily on short-term investments, and very few investors think long-term.
My advice, based upon my years of experience and confirmed by speakers at the Congress, is that you should invest in high quality companies at reduced prices. If a company is experiencing short-term difficulties, that's OK; in fact it might even be preferable. Investors tend to overreact and send the stock prices of very good companies absurdly low when short-term disappointments surface. Long-term investors can overlook those problems and concentrate on the three to five year prospects.
An example of a high-quality company with short-term problems, but with a good long-term outlook is Colgate-Palmolive (CL), which is a company that I recommended in Cabot Wealth Advisory last month. Four years ago, the company was plodding along at an agonizingly slow pace, and the stock was going nowhere. Management created a comprehensive plan to overhaul the entire company to become significantly more efficient and more profitable. Progress started slowly, but long-term investors have been richly rewarded. CL shares have increased 50% during the last four years, despite the recent drop in the stock market.
We've been able to secure a special discount for Cabot Wealth Advisory readers to attend the next Value Investing Congress, taking place May 5 and 6 in Pasadena, California. Register at the link below with discount code P09CWA1 before November 30, 2008, and save $600 off the early bird rate--a total savings of $1800.
International Business Machines (IBM) is another company that is transforming itself from a slow-growing company into a market leader with faster revenue and earnings growth.
IBM is the world's largest and most recognized technology company. The company makes and sells computer hardware equipment, application and system software, and offers consulting and outsourcing services. Revenues will top $100 billion in 2008, yet despite IBM's size, its earnings are expected to grow at a 15% clip during the next three to five years. Top-notch research--IBM garnered more new patents than any other company in 2007--and overseas expansion will fuel future growth.
IBM has evolved from being a computer hardware maker to a systems, services and software company. Management is now focused on providing products and services to help corporations in the U.S. and abroad to cut costs, increase security and manage risk. Recent new product and service launches will help provide rapid growth during the next several quarters. IBM's services backlog is a huge $120 billion. Long-term service contracts will ensure stable growth despite economic uncertainty. Earnings per share growth of 15% is a reasonable expectation during the next three to five years.
IBM shares sell at a bargain 10.3 times next 12-month EPS. The dividend was recently increased for the 13th straight year and now provides a 2.2% yield. I fully expect IBM shares to advance to our Minimum Sell Price target within one to three years.
J. Royden Ward
For Cabot Wealth Advisory
Editor's Note: Cabot Benjamin Graham Value Letter follows the system laid out by the father of value investing, which has brought investors returns of 20% since its inception 80 years ago. If you like to patiently hold on to undervalued companies while they climb higher in price, this system is for you. It works well in any market, especially when stocks are cheap like right now. Click the link below to learn more about how you can safely see double-digit returns.