Tuesday, June 2, 2009

A Way to Be Proactive Even If You Missed the Rally

Feel as though you haven’t participated in the violent rally in stocks that has occurred since the beginning of March? I know I sure haven’t. My conservative stance on the equity markets has looked absolutely foolish with the benefit of hindsight. Oh well, better to learn these lessons now than when there is more than just my own capital at stake. After the recent run-up it would be easy to become paralyzed. As a value investor I like stocks less and less as they go up. I now feel like the guy waiting to buy the big screen TV because he thinks the price will be lower in six months. In addition, to some extent the appreciation in US stocks seems to have decoupled from what is going on in the underlying economy. While there have been plenty of perceived green shoots and news that is just less bad than expected, there still are a number structural weaknesses that stem from continuing unemployment, falling house prices, consumer de-leveraging and declining company profit margin. Given the combination of less attractive valuations and concerns about the future, it would be easy to throw your hands up and try to wait (im)patiently on the sidelines. However, I have a suggestion for investors who are looking to be more proactive.

The first thing an investor can do is identify companies that he or she feels have sustainable business models, credit-worthy management teams, and little dependence on the capital markets but are not trading with a suitable margin of safety at the current levels. John Templeton famously employed the strategy of researching companies that he felt fit his criteria for a quality business, establishing a price that he would buy such a company at, and placing open-ended orders for the stock at that value. This served a few desirable purposes.

First, it is often most difficult to buy when a stock or the market is continually falling. Therefore, having a pre-placed order means the decision has already been made to buy at a certain price, regardless of the pessimism in the market. As long as the long term fundamentals for the company have not deteriorated meaningfully, this strategy takes a lot of the emotion out of investing. This kind of buying discipline can really lead to outsized returns because it entails being greedy when others are by definition acting based on fear. Also, instead of deciding to forgo researching a company that you would like to own, this strategy allows you to evaluate companies without the current stock price in mind and likely diminishes any potential anchoring bias (for example a fixation on the 52 week low/high or current stock price).

This type of investing is something that I have recently begun to dabble in as well. Along with searching for unloved net-nets, I have been updating my prior research on stocks I really liked to reflect the multitude of changes that have occurred in the global markets over the past year. If you look at any of the equity research on my blog, you will see that I establish prices for which I would be willing to accumulate shares. As opposed to stopping my research half way through when I determined that the stock was not an immediate buy, I completed the research. Then, I established an intrinsic value and came up with a price that I would be willing to pay that included a margin of safety that would allow me to sleep at night, given my company specific concerns. Now, this may be a strategy that is far too conservative for some investors. It also could be seen as a waste of time, especially when you consider the amount by which the stock would have to fall to reach my price target. However, by doing a thorough analysis of these companies I have become very familiar with fundamentals of the specific sectors and know enough about the competitors that I would be comfortable investing in them with only a little more research in the event those stocks pulled back substantially.

Let me briefly go through an example of how this process works. Just yesterday I finished updating my research of Cerdayne (CRDN), a company whose main business is supplying ceramic body armor to the US military. Shares of CRDN fell dramatically throughout the early part of this year as a result of the general malaise in the market combined with concerns regarding the timing of armor orders and diminished troop levels in Iraq and Afghanistan. Despite having a very tough Q1 2009 in which many of my concerns were realized, the stock has run up from $14 when I first began looking at it to over $22 now. However, from my perspective there has been no change to my fundamental thesis for why I believed the stock did not offer a significant enough margin of safety in early March. At that time I suggested a price around $10.50 would compel me to begin accumulating shares because at that price I felt that the company’s strong balance sheet provided sufficient downside protection.

Due to the continued uncertainty regarding armor orders and a tough operating environment for the rest of CRDN’s businesses, I still believe that my previous entry point is justified. While the shares would have to fall more than 50% to get back to that level, with as volatile as this market has been anything is possible. In the worst case scenario the stock never gets there and my order never gets filled. The best case scenario is that I own a debt-free company with some real growth potential at a very attractive price. From my point of view it is a win-win scenario; kind of like a lottery ticket I don’t have to pay for. Hey, you never know.

(Picture courtesy of Robin Mills at Elfwood.com)