The Strategy That Makes Sense Right Now

Since Oct. 1, there have been seven days where the Dow Jones Industrial Average has swung more than 10% between its low value and high value in a single session. That is an insane level of volatility.

You need to look back eight decades, all the way to the throes of the Great Depression, to count a total of another seven daily swings of that magnitude.

I'm speculating here, but all that volatility must be taking a toll on retail investors. Maybe we're bleeding red ink, or cashing out and moving to "safer" investment choices, or burying our heads until this passes. To actually invest in these times, you'd need nerves of steel.

After all, that particular market average is a collection of 30 of the largest and best-known U.S. businesses. Just imagine the swings among smaller and more typically volatile stocks!

Do prospects change 10% daily?
While a failing company's apparent intrinsic value can evaporate in a heartbeat, healthy and profitable firms tend to have far more stable long-term prospects. When the stock of a strong company gyrates that much, it's probably a sign that the market has lost touch of the connection between those shares and the ownership stake they represent. Once that connection is severed, stocks can trade dramatically above or below what their underlying companies are truly worth.

That basic fact formed the basis of value investing pioneer Benjamin Graham's approach. If you don't know Benjamin Graham, you likely know of his proteges Warren Buffett, Walter Schloss, Bill Ruane, and Charlie Munger -- some of the most successful investors we've known. (And, by the way, if you really don't know of Graham, add The Intelligent Investor to your holiday wish list -- you'll be glad you did.)

Graham is widely considered the founding father of value investing, the strategy that aims to profit from the severed connection between "price of the stock" and "value of the underlying company." Graham wrote and taught about buying stocks with those three magical words, margin of safety. As I've written before:

The margin of safety recognizes that there is a difference between a company's current market price and the intrinsic value of the company. When market price is significantly below its intrinsic value, the difference represents a margin of safety. While it's not an absolute guarantee of investment profitability, most investors would rather buy a company for less than it's worth and wait for its price to catch up to its value than buy a company for more than it's worth and hope for its value to catch up to its price.

The margin of safety concept allowed Buffett, Ruane, Munger, et al. to get rich by investing. But alas, it's easier said than done. Typically, there are good reasons why stocks go on sale. After all, every investor wants to make money, and nobody would rationally and willingly part with shares for less than they thought those shares were really worth.

Today's market craziness
As an individual investor, you can't prevent such wild swings. But what you can do is figure out how to profit from them. To do that, there's no better teacher than Graham. And right now, value is the only strategy that makes sense to me.

Just remember: No matter what the market's daily moves do to a stock, its true worth -- intrinsic value, as Graham called it -- is really tied to that company's long-term prospects.

Dumpster-diving for fun and profit
Examine one of Buffett's most famous investments, his purchase of American Express (NYSE: AXP  ) after the Salad Oil scandal knocked the company down. Graham's own strategy included buying heavily damaged "cigar butt" companies for less than their likely liquidation value. In each case, there were very real -- but not insurmountable -- factors holding those shares down.

These days, the utter collapse of the lending market and the newly declared year-old recession have knocked the stuffing out of stocks in general. While the whole market is down, some companies have fallen even further than the average stock. Just like in Graham's days, however, the question that matters isn't, "How far have these stocks fallen?" but rather, "What are these companies really worth?"

If the answer to that question is, "They're worth way more than what they're trading for today," then you just might have uncovered some of the tremendous values available today. Take a look, for instance, at these companies, just how far they've fallen, some of the reasons behind their descent, and one measure of their cheapness:

Company

Year-to-Date Return

Normalized Trailing P/E Ratio

Forward P/E Ratio (Estimate)

Source of Panic

Pfizer (NYSE: PFE  )

(22%)

11.1

6.7

Looming patent expirations.

Caterpillar (NYSE: CAT  )

(38%)

7.6

8.3

Heavy infrastructure in a slowing global economy.

UnitedHealth Group (NYSE: UNH  )

(63%)

7.2

6.9

Possibility of nationalized health care.

Johnson Controls (NYSE: JCI  )

(42%)

9.8

10.7

Significant exposure to automakers.

Marathon Oil (NYSE: MRO  )

(57%)

4.7

5.5

The bursting oil bubble.

Nucor (NYSE: NUE  )

(24%)

4.8

9.2

Slumping steel prices as China's growth slows.

Source: Capital IQ, a division of Standard & Poor's.

Now, I'm not saying that those companies are screaming buys right now, but they are definitely worth further research. Graham once famously said that in the short run, the market is a voting machine, but in the long run, it is a weighing machine. If you can see long-run strengths amid the weak current stock prices and dismal near-term projections, then you have what it takes to follow in Graham's footsteps as a value investor.

You have to go back about eight decades -- to the time Graham was perfecting his successful strategy -- to see the same level of volatility we've seen in the Dow since October. This chaotic volatility has many businesses trading for bargain prices, and our team at Motley Fool Inside Value is planning to be on the leading edge of the next great value-driven recovery. If you'd like to be a part of it along with us and see the companies we're recommending today, try us out for free for 30 days. Simply click here to get started.

At the time of publication, Fool contributor and Inside Value team member Chuck Saletta owned shares of American Express. Pfizer is a Motley Fool Income Investor pick. UnitedHealth Group, Pfizer, and American Express are Inside Value picks. UnitedHealth Group is a Motley Fool Stock Advisor recommendation. The Fool owns shares of UnitedHealth, Pfizer, and American Express. The Fool has a disclosure policy.


Read/Post Comments (7) | Recommend This Article (35)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 12, 2008, at 10:30 AM, TexasLonghorns wrote:

    In this market you once again are finally going to see the sane factors of "earnings, free cash flow and no debt", actually mean something to intelligent investors. Analysts on the Street have been bumbling iditots for years and most of them should be selling used cars instead of the daily barrage of upgrade, downgrade. Uhmmm....come to think of it, most of them soon will be driving used cars if they can afford them as their jobs will be gone. I'm all in and keep buying strong, value oriented blue chips with no debt, wide moats and good recessionary earnings. Hang on to them and you will be rewarded. Just going to be a bumpy ride. Day traders buying the dips and selling the rips and Hedge Funds deleveraging are ruling the Market right now.

  • Report this Comment On December 12, 2008, at 3:22 PM, phillyish wrote:

    I wholeheartedly agree (with TexasLonghorns) that the Analysts on the Street have all turned into used car salesmen. Only mildly referenced is the fact that Everyone now uses computers, which all "help" drive the volatility and massive mood swings that we now see each day.

    The only way that "we" (not the machines) can survive in this climate is to refuse to play along; by keeping one's head down, do the research and buy the ones that will still be there in five to ten years (and beyond.)

    You don't win or lose until you sell.

  • Report this Comment On December 15, 2008, at 9:32 AM, WakeJKirk wrote:

    Great article.

  • Report this Comment On December 20, 2008, at 6:59 AM, WimWouters wrote:

    People all around are looking for sound advice. Many now are invested in cash. OK nice yields, though for how long ? Soon high yield savings accounts here in Europe will come down to maybe 2% and lower, state bonds would offer slightly more and the ocean of cash poured into markets will start pushing inflation. At that point we've got be 'on' the train.

    Just as rates fell into the abyss when sellers found few buyers...we'll soon (?) find out about the reverse. Thanks Motley Fool for your help in choosing wisely.

    Wim Wouters, Belgium

  • Report this Comment On December 21, 2008, at 9:30 AM, 181736065 wrote:

    Wim sys: "Many now are invested in cash. OK nice yields, though for how long ?"

    Consider this.......

    If you were in cash this year you are UP 20% - 40% compared to almost all alternatives..

    In fact, the US stock market (S&P) has wound up about FLAT for the last 12 years, while cash would have given you a compound return of at least 5%, without all the volatility.

    If inflation re-ignites, (as many economists now believe) bonds will tank and so will most stocks, however your cash (in money markets) will keep pace.

    As a matter of fact, the average money market pays a good 2.5%, way above inflation.

    So, your logic only holds for what you foresee for the future.. not what may happen. And it sure doesn't hold for what's occurred over the last 12 years.

  • Report this Comment On December 21, 2008, at 10:15 AM, BKWI wrote:

    All in cash except for a small position in Berkshire has made me better off than any in my family. Compared to them, I am up nearly 40% on a 4% earn rate in my retirement accounts (a stable value fund). Listening to the bulls and bears hasn't done much as I can't watch the market day in and day out to catch the short term options based buys. Even the Motley folks are tough to follow and all are down... since December 07.

    I am comfortable doing what I am doing and that is what is most important.

    BKWI

  • Report this Comment On December 27, 2008, at 4:40 PM, beckle wrote:

    I stayed in for the entire ride down and have lost about 300,000.00. How long do you think it will take to recover these loses?

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