How Declining Markets Boost Returns

It's natural in this environment for investors to show reluctance to stocks. Even the best money managers like to have cash available to take advantage of short-term market mispricings. But as difficult as it is in the short term, as markets decline you should invest more.

Warren Buffett sold out of PetroChina (NYSE: PTR  ) while everyone else was plowing money into Chinese equities. Why? Chinese equities have mounted astronomical gains over the years, and PetroChina reached a fair enough value for Buffett. He has been around long enough to know that when everyone else is excited, it's best to leave the party early. Excited investors can allow emotional tendencies to take the place of rational analysis.

Now's the right time to get excited
As markets decline, serious investors are excited. The S&P 500 index is down more than 14% from its October highs. Amid all the poor investments, market declines lead to more attractive opportunities. And investing in declining markets, believe it or not, will yield fewer investing mistakes because they are less likely to buy anything at the top.

Investors use research and analysis to find companies that will provide satisfactory rates of return while protecting principal. If you allocate your capital this way, then you welcome declining markets. If the Dow Jones were to suddenly fall to 10,000, I would be 100% invested; conversely, if the Dow were to jump to 15,000, I might only be 50% invested. Consider the following illustration:

You created a portfolio of 10 securities with an aggregate intrinsic value of $100, and your total cost was $50. This portfolio is trading at a 50% discount to your assessed intrinsic value -- a 100% rate of return over two or three years.
Over the next month, market indices decline 15%, and your portfolio, being concentrated, slips 30%. Your portfolio is now valued at $35 but intrinsic value still remains at $100.
Your portfolio is now trading at greater discount to intrinsic value, thus a more compelling rate of return and an even better margin of safety.

As markets decline, sound businesses usually decline with them. As a result, if you can stomach a little volatility, your returns will go up as a result of participating in even greater bargains.

The assumption is that you arrive at an acceptable estimate of intrinsic value and that you only buy securities that are undervalued to begin with. Such undervalued businesses can become more valuable with declining share prices.

Intrinsic value can change
Declining markets do a wonderful job of exposing sloppy, unsustainable business practices of companies that "were caught swimming naked when the tide went out."

One-time mortgage highflier New Century Financial was forced to file for bankruptcy. Recently, rumors were flying that Countrywide Financial (NYSE: CFC  ) was headed for permanent troubles until the bailout purchase offer by Bank of America (NYSE: BAC  ) gave hope to shareholders in salvaging some part of their investment.

Back in August, I wrote about how Beazer Homes (NYSE: BZH  ) appeared to be a bargain with a book value of $28 versus a $12 stock price. Yet a quick look at the assets provided evidence that intrinsic value had deteriorated alongside the stock price. At the time, most homebuilders like Hovnanian (NYSE: HOV  ) , Centex (NYSE: CTX  ) and Pulte (NYSE: PHM  ) were also "cheap" based on price-to-book value. But after considering the possible land impairments and inventory charges, it looked as though further declines were coming.

When your investments decline, you need to be sure that intrinsic value has not been impaired as well. If not, then back up the truck.

Simple but not easy
Watching a continual market decline, day in and day out, wreaks havoc on investors. Get used it. If you plan on investing for a substantial period of time, you will experience recessions, bear markets, bubbles, and panics. And you will also make some bad decisions. But if you can ignore what the market does daily and focus on what your companies do, you'll find it far simpler to ride out the declines relatively unscathed.

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