A value-oriented investment approach in the style of Graham and Buffett does not focus on bull market performance. In fact, by definition, true value investing always focuses on weathering the bear market storms and coming out relatively unscathed. During bull markets, a lot of people are mistaken for investment geniuses when in fact it's the rising tide that's moving them up in the world. Bear markets, on the other hand, distinguish the intelligent investor from the fly-by-night speculator. My approach and the ultimate purpose of value investing is to outperform bear markets.
In his 1961 letter to partners, a 31-year-old investor in Omaha named Warren Buffett told his partners that they should be judging him during times of turmoil and not times of jubilance. "I would consider a year in which we declined 15% and the [Dow Jones Industrial] Average 30%, to be much superior to a year when both we and the Average advanced 20%." Very early on in his career, Buffett was aware that performing well during market turmoil was the key to long-term success as an investor. During the 13 years that Buffett ran his partnership, not only did he destroy the Dow Jones Average during both bull and bear markets, but he also never had a down year. So while other investors have come along and produced records that outshine Buffett's, its Buffett's preservation of capital that has allowed him to compound money at such a staggering rate.
A simple illustration makes my point. Consider two investors starting at the same point in time with the same initial capital. In year one, investor A suffers a 30% loss and investor B suffers a 10% loss. In year two, investor A enjoys a 50% gain and investor B enjoys a 30% return. After two years, investor A's total capital has appreciated 5% and B has about a 17% overall return. Clearly, the preservation of capital during the down market enables the enterprising investor to outperform over a satisfactory period of time.
Be greedy when others are fearful ...
When he was a 21-year-old student at Columbia (so the story goes), Warren Buffett one day told his classmates to shut the door so he could tell them how to get rich investing in the stock market. When he had their attention, Buffett remarked, "The key is to be greedy when others are fearful and fearful when others are greedy." Whether or not this took place as described above is beside the point. Buffett did at some point say the aforementioned quote, and it is arguably the most useful piece of advice in investing.
Back in the 1960s, Buffett bet big on American Express
Today, Mr. Market is fearful of the turmoil in the subprime lending and credit markets. As usual, Mr. Market's emotions are running wild, and stocks for all types of businesses are selling off like crazy. In most cases, the selling is justified, as the greed that prevailed over the lending led to unsustainable asset valuations. Fortunately, Mr. Market's erratic behavior can often lead to babies being thrown out with the bathwater, and thus some very attractive possibilities for true value investors.
It should come as no surprise that Buffett has been buying lately. Last week, it was reported that Berkshire had acquired 10 million more shares of Burlington Northern Sante Fe
The current market environment is shaping up to be rife with excellent companies at very attractive valuations. As always, the first step is to approach any investment very carefully in order to avoid mistaking a value trap for a bargain. But making significant investments during times of maximum pessimism is one way value investors beat the crowd.
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Bank of America is an Income Investor recommendation. Berkshire Hathaway is both a Stock Advisor and Inside Value recommendation.
Fool contributor Sham Gad is managing partner of the Gad Partners Fund, a value-focused private investment partnership. He has no positions in the companies mentioned. The Fool has a safe disclosure policy.
