Use Market Weakness to Buy Great Companies at a Discount

On Monday the market pundits were heading full speed for the exits.  Italy’s election and bearish Fed meeting notes were blamed for the sell-off.  Adding further uncertainty was the looming sequester.  For two days the sky was falling and as they are wont to do the experts extrapolated short-term data to conclude the market had moved too far too fast.  That was Monday.  
 
Tuesday the DJIA rose 115.96 points (.84%) and Wednesday the index rocketed 175.24 points or 1.26%.  The reasons subsequently proffered were clarification from the Fed that it would continue easing (read:  the Fed will continue to buy treasuries and mortgage-backed securities to ensure interest rates stay at current historically low levels) thereby forcing investors seeking yield and total return into riskier assets, like stocks.  Traders believe this is good for the market.  And, bam, the rally that wasn’t suddenly is once more.  
 
For individual investors this head-spinning day-to-day volatility is no way to make stock buy and sell decisions. We can’t compete with Wall Street traders.  Nor do we have to.  
 
When the frenzy begins, step back and take a good look at your portfolio.  Are you properly diversified?  Do you have an inordinate concentration in tech stocks, for example?  Or in one holding?  Are you missing exposure to a particular industry, say cyclicals?  If so, take a look at  the industry leaders to determine if there are any bargains to be had.  After the election in November when investors were worried about the impact of rising taxes and the then Washington crisis du-jour, the looming “fiscal cliff,” the market sold off and I saw an opportunity to increase my holdings in cyclical stocks (among other industries).  
 
Caterpillar (CAT) was coming off a lackluster year and the trailing p/e on the stock was hovering around 9x 2011 earnings, a significant discount to its historical average of 15x trailing earnings.  Analysts, while admitting it was one of the deepest discounts ever applied to the stock, were also quick to cite the global economic slowdown as a reason not to own the stock.  But the price was already reflecting those concerns.  I began picking away at the stock and continued to buy as it went up.  My average cost is $86.99.  The stock recently spiked at close to $100 and has come back to the low $90’s closing yesterday at $92.49.  If it spends more than a few days below $90 per share I’ll be adding to my position.  
 
As a long-term investor I don’t need CAT to return 50% in six months.  I am look for 10-12% per year which means that some years I may get 3% and some years I may get 20% or a decline of 10% but, every year I will be collecting my (currently) 2.25% dividend yield which beats money market or intermediate bond returns and I have the potential for dividend growth and price appreciation. 
 
Of course there is the risk the stock will decline.  In fact, because it is a cyclical stock and its earnings are subject to the ups and downs of the economy, I expect to experience periods when the stock declines.  That is why I own a portfolio of stocks and why I only purchase shares of well-managed companies.  However, good management will find a way to get the company back on track.  And they almost always do.  I am owning this stock for the total return it will produce over the next ten to twenty years not the next few weeks.  Look at the chart below courtesy of  Wells Trade.  I have selected the longest period availble and compared the performance of CAT with the S&P 500.  You will note that some short-term periods have not been good for the stock (or the market for that matter) but over the long-term, in good economic times and bad, CAT has produced an enviable return.  
 
 
Price chart, Wells Trade
 
I am willing to take the short-term risk when I buy high-quality companies at discounted price levels.  Frequently the lower price already reflect the risk.  As I repeatedly told my teenagers:  learn to manage expectations and you will increase your chances of success.  Stocks that Wall Street hates,  if their managements adequately manage expectations, often provide great long-term opportunities.
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Focus On Fallen Angels–Patience is the Key

In my previous post, I suggested that investors watch stocks they are interested in before plunging in. The title of the post was “Patience is Perspective.” In my thirty years of investing waiting has rarely cost me money. Trying to catch a falling knife has. Because I tend to buy “fallen-angel” growth stocks, waiting for the dust to settle is imperative. Fallen-angel’s present the greatest difficulty and the greatest potential for the value investor.

Fallen-angel growth stocks are well-managed, fast-growing companies that have unexpectedly hit a road bump (higher raw material costs and consequently shrinking margins: Coca Cola in the 1980’s, slower sales or, worse, obsolescence due to new competition: Eastman Kodak–who?–and the emergence of digital film, or new, ground-breaking technology which impacts the primary product offering: Hewlett Packard in the shadow of the iphone and ipad).  Because growth stock investors tend to focus on price momentum they are rarely patient with earnings misses and often unload the stock at the first sign of weakness.  The fallen-angel stock presents a great opportunity for the value investor but the important thing is not to become too eager to buy a former growth icon.  Value investors must remember that growth stock investors can and will bail out of a stock much quicker than the more price sensitive investor can accumulate holdings.

So, what to do?

As soon as a stock disappoints, add it to your wish list.  Begin tracking the price.  And wait.  The former darling will pass through the three stages of stock market grief:  disappointment, hate and finally, neglect.  Neglect is the point when the stock price flat lines:  the intelligent value investor’s buying opportunity.

Next post we will examine the price performance of an actual fallen-angel growth stock.

Patience is Perspective

 “Even if you’re on the right track, you’ll get run over if you just sit there.”

Will Rogers

 

One of the reasons individual investors abandon the stock market is because they fear they can’t compete with the Wall Street pros.  And, generally that is true.  We can’t compete with them on day to day or intraday trading.  They are setting up the game and driving the narrative.  They are in the middle of the action and we are home with a computer and a TV and dinner in the over.  I’ll happily concede the day trading to the pros.  I would rather follow a civilized and proven strategy of investing for the long term.

That is not to say that long-term investing is easy.  It is not.  Often we are buying in the face of market sell-offs and the talking heads are predicting that it is different this time.  That what’s worked in the past, will work no longer.

In my thirty-plus years of investing in and watching market trends, I have found that employing common sense and patient discipline are the primary factors to success as an investor.  Following the trends is a dangerous game–you must be incredibly agile or you may just get run over.

So, begin by watching the stocks you are interested in.  Observe how they perform in up and down markets.  And while you’re on the sidelines you’ll learn a great deal about how the game is played, be more likely to see the train coming.  Patience lends perspective and provides cover from the speculators.  By watching and learning you will become a better investor when you finally do decide to jump on the stock market locomotive.