For some reason, I was struck the other day by the urge to drop by the library and grab a copy of Tom Wolfe's astronaut tale, The Right Stuff. If you've never read it, I recommend you do. It opens with a humdinger. Chapter 1 is a 90 mile-per-hour, expository "proficiency run" down a horrifying stretch of hairpinned psychological asphalt. It provides a peek at the inner workings of fear and relief that bear a direct comparison to the thought process we go through as investors although, granted, the stakes for us are much smaller. Our hides are not on the line. It is just money, after all.
The right fear
In "1/The Angels," the author describes the sheer terror experienced by the wife of test pilot Pete Conrad when, during the normal workaday week, the smoking bang "out there," a bang she couldn't hear or see, would be followed by a jingle, the telephone. It was the wives' communication network. "Something" had happened "out there." "Something" meant "one of our husbands has crashed" and "out there" meant "we don't know who."
Weeks, months, and years of this left poor Jane Conrad in such a state of continual anxiety that there were days when she could look out her window, awake as well as in the dark hours of sleep, and she could see a solemn duty officer making his way up her front sidewalk to make the big announcement. The hallucinations could visit any time Pete went out the door to latch himself into the guts of the Navy's latest gleaming silver beast. But it was a terror suffered in obscurity.
The chapter ends years later, with Conrad's wife -- now an astronaut's wife -- standing at her home while fidgeting, microphone-wielding pressmen peer in at her like she's a lobster in a seafood-restaurant tank. Pity. Enthusiasm. The voyeuristic thrill. How did she feel? Was she afraid? In fact, Wolfe tells us, Jane wanted to laugh in their faces. She wanted to look at them and blurt, "Why ask now?"
The wrong timing
The laughable irony that Jane was choking back was borne of the discrepancy between real risk and perceived risk. She had already lived through real risk -- terrifying, hallucination-inducing risk -- the near 25% risk that a career Navy flier like her husband would crash and burn. She'd lived through that every day. Yet no one wondered about her anxiety until the space age, when Pete's job was actually much safer. At that point, there were hundreds, even thousands, of engineers, testers, and technicians assigned to run every possible scenario regarding Conrad's ship. Hundreds of test runs. Days of conditioning so that every possible kink was worked out of the system. Nothing was certain, of course, but, the odds were certainly better than in the days before, and by then, Jane was desensitized to the terrors. But only then did anyone else think to worry. Why? Because, to them, riding in a little, thin-skinned Spam can atop a thousand-ton Roman candle seemed much more dangerous.
Psychology of the street
The psychology of the stock market is very similar. The perception of danger or risk is more important in moving a stock than any reality. This is summarized in the worthless Wall Street adage (we ought to have a permanent shrine for these): "Never try to catch a falling knife."
In fact, the crushing fear comes and, indeed, often reaches its peak -- which is to say a trench in the stock chart -- at the stage when, in fact, the better part of the financial risk is being worked out of the system. This often works to the advantage of investors looking at getting in.
Don't catch a falling knife? Please. I catch them all the time, as do my colleagues at Motley Fool Inside Value. And, contrary to the adage, falling knives have invariably been my best investments. Sure, you need to catch the right knives, but finding them takes only a little elbow grease and a bit of fifth-grade math.
Scary safety
There's a simple reason these scary stocks have turned out well for me. It's because the market becomes obsessed with the fear and stops seeing that that very fear makes things safer for buyers. In the perception of panic, the market -- the all-knowing bastion of the Wise -- turns wild and joins forces with the media, those glaze-eyed, microphone-wielding Jimmy Doolittles on Jane Conrad's lawn, or CNBC's hourly trading-floor shows. Behind the facade of financial Wisedom and under those pork pie press hats, there's a singular, fear-driven question: "How can anyone buy this when it's down? That's scary!"
But scary can be good. Take SanDisk (NASDAQ:SNDK), for instance. When it was too big for its own britches and trading at a nosebleed P/E a couple of years back, everyone loved it. But at those prices, there was little margin of safety. One small slip, and the stock would make a smoking hole in the Street. And it didn't even take much of a slip, just earnings that were less great than expected. SanDisk made that smoking hole as all those sanguine buyers, the ones who refused to see the danger when it was greatest, starting flooding for the exits.
I bought this stock several times, months ago, when the Wise guys were still afraid to touch it, ignoring the obvious reality of the situation. Guys with Italian suits, six-figure salaries, and the freedom to fly to Asia to visit semiconductor plants somehow didn't see what a simple Internet search could tell the average Joe Keyboard.
There was firm Flash pricing and good evidence of SanDisk's growing ability to sell to the market on its own terms -- to everyone from Costco (NASDAQ:COST) to Canon and Motorola (NYSE:MOT) -- while keeping its costs trim. But the stock was down!
Fear continued to pummel the company, which was growing earnings at better than 20% and would go on to double that rate, until it was selling at a P/E in the high teens. With a strong cash cushion. The biggest name in the biz!
"But it had gone down!" said the Pork Pie Doolittles. It had to be scary because it seemed scary. Well, even an armchair investor could separate real fear from the perceived fear. I was buying. Fifty percent later, the Street began sniffing around. But still, there was fear. The biggest name in the computer media biz, Apple (NASDAQ:AAPL), came along and did SanDisk a huge favor, releasing the iPod Shuffle and Nano, thereby soaking up a giant chunk of the world's flash memory, keeping prices firm, even sending them the opposite way that had been predicted. Still, people were freaked.
One hundred percent later, the loudest "buys" started to show up, after, of course, the margin of safety had been worked back out. Those of us who saw the real risk and reality a while back just sit back and smile with our doubled dough.
Not an isolated incident
Still think a regular Joe or Jane like you can't spot safety in the scariness? Think again. We all can. And we don't have to go to the fickle tech world to find them. Opportunities like this come along all the time, even in some pretty obvious places. Take Nokia (NYSE:NOK) a couple of years back, when it sank like a brick and washed up on the rocks at the bargain price of $12 a stub. Or good old burger-flipping McDonald's before that. People were actually saying McDonald's would disappear forever! The real trouble was that the company couldn't deliver a hot burger and crisp fries. Once Jim Cantalupo beat that simple concept back into the Micky D procedures manual, the sales came back, and so did the stock.
For a few big names that weren't exactly falling knives but are still recovering from unwarranted malaise, take a look at 3M (NYSE:MMM) and Home Depot (NYSE:HD). It's been a few months since I started salivating over these companies, while the Streeters and Pork Pies were watching with their jaws hung slack. The stocks were being beaten down by short-term concerns such as a departing CEO and dire predictions about Home Depot's potential negative exposure to as-yet-unseen vagaries in the housing market. Guesses about guesses about guesses! The boss leaving for greener pastures? What is so scary about that? Nothing, except that it sure seemed scary.
As a result, the shares reached the point where they were far safer to buy. Same great companies. Same great futures. Safer entry price. I couldn't hold back. And I don't think it's a coincidence, by the way, that my colleague Philip Durell turned out to be eyeballing the exact same stocks. Both later became formal newsletter picks and have offered solid, market-beating returns for us since.
The Foolish bottom line
Listen, sometimes the falling knife will cut you. You won't hear any of us on the Inside Value team bragging about Fannie Mae's performance, for instance. But the idea isn't to be right all the time, it's to be right often enough to beat the pants off the market. And the best way I know to do that is to buy when others won't, to be "greedy when others are fearful," as Warren Buffet has put it. It's then that you earn your big green, on the buy. When others are scared and you know the real story, your odds of getting a good margin of safety are just much better.
So when you hear the Streeters and Pork Pies complaining about a stock and exhorting you to run for the hills, consider doing just the opposite. At least take a look to see whether the fear is real or perceived, or maybe just overdone. If you've still got butterflies in your stomach, you can always discuss the situation with the community at Inside Value -- or even crib off our official picks. (We'll let you try the service out for the grand sum of $0. It doesn't get any safer than that.)
For related Foolishness:
- How do you buy low and sell high? It's not rocket science.
- Think value's not glamorous? Try some dirt-cheap dream stocks.
- Learn how to exploit the fearful.
Seth Jayson will take those falling knives, thank you. At the time of publication, he had shares of SanDisk (and covered calls), 3M, and Home Depot but no positions in any other company mentioned. View his stock holdings and Fool profile here . Home Depot, 3M, and Fannie Mae are Motley Fool Inside Value recommendations; Costco is a Motley Fool Stock Advisor pick. Fool rules arehere.
