You probably consider this title salacious, but "extreme" isn't even my word. It's Bill Nygren's. He said on his fund's fourth-quarter conference call, "The values that we're seeing today in financials and retailers are extreme."
He also confessed, "I'd love to be coming into the office every morning and putting 20 million new dollars to work each day, because I think the opportunity is very great."
That's right. One of the world's best investors was positively giddy about investing at the end of last year. What's happened since is the market's dropped more, with financials and retailers bearing the brunt of the storm. If the values were extreme 8 months ago, then what are they today?
Ay, there's the rub
Bill Nygren -- if you don't know him -- is a value investor. That means he waits for market pessimism to drive the stocks of great companies down to prices far below their true worth. Then he buys and profits. The key to such a strategy is to be able to act contrary to widespread market sentiment.
The eagerness to bet against the grain has led to some pretty big losses this year for Nygren's funds. First-quarter buys of Merrill Lynch (NYSE: MER ) , Citigroup (NYSE: C ) , and Sprint Nextel (NYSE: S ) are all down double digits, according to gurufocus.com.
Yet, over the long term, Nygren has profited handsomely with this strategy. His Oakmark fund has returned 15% annually since August 1991, versus just 4.8% for its peer group. That's good. Really good.
All good things must come to an end
But the tables have turned. Thanks to those bets above and a number of others, Nygren's Oakmark fund has lost nearly 13% of its value over the past year. Worse, discouraged shareholders are pulling money from the fund.
Not only can Nygren not buy as much of the extreme values he sees, but he needs to sell holdings he thinks are cheap to meet redemption demands. This is Nygren's paradox of value investing: "When the opportunities are the greatest, confidence in the approach is at its lowest."
A tough break, but that's life
When you're done feeling sorry for Nygren, ask yourself what you've been doing lately. He's seeing redemptions in his fund because individual investors are panicking. They've lost money in this terrible stock market over the past six months, and they don't want to lose any more. So they throw a tantrum, pick up their ball, and go home.
This is crazy.
Don't be crazy
The good news is that if you're willing to stick with stocks, you can take advantage of the market's craziness. As Warren Buffett's longtime friend and colleague Charlie Munger observed last year:
There are at least two kinds of markets that are inefficient. One is those that are so small they are neglected. ... The other are the markets wherein really crazy people are doing really crazy things -- particularly if they're selling.
All of this craziness results in "crazily mispriced securities." Buy them, and you'll do well -- just as Nygren, Buffett, and Munger all have.
But today you can do even better. See, not only is the market selling crazily today, but it's doing so most crazily in the generally neglected small-cap universe. Put neglect together with insanity, and you can find some outrageously cheap buying opportunities.
Some stocks are cheap, but buyer beware
Recognize, of course, that buying stocks -- and small-cap value stocks in particular -- is not for the faint of heart. Though the total return potential is tremendous, volatility is inevitable. Noted value investor Richard Pzena has said that you're not doing value investing correctly unless your portfolio makes you want to throw up. (Recent losses at Melco Crown (Nasdaq: MPEL ) , SM&A (Nasdaq: WINS ) , and W&T Offshore (NYSE: WTI ) in my own portfolio have certainly had me a little queasy.)
But while we guarantee volatility, we can mitigate that volatility by taking the long-term view, drilling down on quality and valuation, and ignoring this crazy market. That's where we're focused for our Motley Fool Hidden Gems small-cap investing service, and we're poised to take advantage of some spectacular prices we see in the market today.
To see our top small caps for new money now, click here to join Hidden Gems free for 30 days. It won't all be smooth sailing from here on out, of course, but we're confident that a diversified portfolio of our picks has significant long-term return potential.
This article was first published on April 17, 2008. It has been updated.
Tim Hanson owns shares of Melco, SM&A, and W&T. Melco is a Motley Fool Global Gains recommendation. Sprint is an Inside Value selection. The Fool's disclosure policy went undrafted in the 2008 NBA draft and will spend the next few years toiling in Europe before returning home to coach a promising small-town squad of amateur disclosure policies.