The Rank Underpants Rally

Early last week, one of my colleagues -- the normally quiet, reserved, and flawlessly polite Motley Fool Hidden Gems analyst TMFBigBlue -- single-handedly extended the U.S. stock market rallies with a bold strategy: He refused to change his undershorts. You think I’m kidding?

Here’s what he wrote Tuesday:

As I stared in amazement at the green on my screen, I got to thinking about what we can do as Fools to keep this thing going. Our trusty valuation models and keen analyses of quarterly statement have failed us -- in the short-term of course. So here's what I came up with ...

In my humble attempt to keep this stock recovery going and in demonstration of my commitment to all of our [Hidden Gems] subscribers ... I am not changing my underpants until we have a down day. Yes, you may mock me. But, if you have any better ideas that have actually worked over the past year or so, I'm all ears. Today has given me some much needed hope and I intend to do my part. (Emphasis added.)

Just look at the results:

*Data from Capital IQ, from 3/10 to 3/13.

And this is just a tiny glimpse of the power of rank skivvies. Over just three days, nearly 480 companies trading on U.S. exchanges gained 20% or more after TMFBigBlue’s brave refusal to adhere to the so-called "rules" of basic hygiene. I can imagine no better example of the power and profit potential of contrarianism.

By now, of course, you know that I’m kidding.
Not about the underpants thing -- as far as I know, and I don’t want to know too much -- TMFBigBlue is standing by his pledge. He’s that kinda guy. But as regards causality, you know the idea of stank boxers spawning a market rally is patently ridiculous.

But here’s the thing: Just about every other example of market-movement causality you see in the financial media is just as insane.

Business journalists and headline writers exist to try and make sense of the financial world. The trouble is, they have no idea why most things happen. And the dirty little secret they don’t want you to know -- lest you stop reading the newspaper or stop watching CNBC -- is that, for most market and stock movements, there is no reason.

But they’ll give you one anyway. For example, “Markets Up on Upbeat Profit Outlook From Citigroup (NYSE:C)” is a ridiculous notion -- given that bank profits are composed of myriad estimates and opinions, that those are merely operational profits that do not include future writedowns, and the likelihood that if Citi realistically valued more of its toxic assets, it would likely be insolvent. Moreover, had markets moved the other way, the weathervane journalists and headline writers would have found another cause for the market rally, maybe “Markets Up on Kelly Clarkson’s New Album Release.” Or, had markets dropped, they would have written something like “Markets Down Despite Citi’s Profit Prediction.”

It’s noise about noise, pretending to explain noise.
Ironically, and unfortunately, during times of market distress, everyone turns even more to nonsense news stories like these for guidance. But what they should be doing is ignoring the noise and reading 10Ks. The future value of our investments has nothing to do with the fears or euphoria du jour. It rests on the cash-production power of the businesses we own through our shares.

Take, for instance, a Hidden Gems recommendation, Dynamic Materials (NASDAQ:BOOM). This specialty welder has a deep moat and turned in a strong 2008. Even though it guided for a teen-ish top-line decline for 2009, it will likely turn in free cash flow for the year north of $20 million. It is still getting orders from the oil industry, and signed the biggest single deal of its history with an alternative energy outfit last quarter. In other words, it looks particularly solid, yet it was recently trading at a market cap in the mid-$60 million range: barely more than 3 times that free cash flow estimate.

Clearly, attention to detail won’t allow you to predict where a stock price will be in a few days, or even a few months. Dynamic Materials has kicked around in the 3 to 4 times free cash flow range for a while, before the underpants rally sent it flying upward some 50% last week.

Attention to detail will, however, let you get an idea of what a company is likely to be worth, and in the long run, that’s what matters. That’s the nuts-and-bolts investing approach we take at Motley Fool Hidden Gems, and we believe in it so much that while everyone else is wringing their hands and sitting out the bad times, we’re doubling down on our homework and moving to a real-money portfolio. Hidden Gems will begin investing a quarter of a million dollars in the upcoming issue, and providing a review of all existing recommendations. If you’d like to check in with our community, get in ahead of the upgrade and see where we’re likely to place our bets; you can take a free trial, on the house. As always, clean skivvies are optional.

Seth Jayson is co-advisor of Motley Fool Hidden Gems. Dynamic Materials is a Hidden Gems recommendation. At the time of publication, Seth had no position in any company mentioned here. He has no comment on the state of his underpants. The Fool has a disclosure policy.