The soundest approach to investing I have ever come across was developed by Ben Graham and David Dodd and published in their book Security Analysis more than 70 years ago. The ideas they wrote about back then hold true today just as strongly as ever.
Sure, markets have grown exponentially since the 1930s, and they're clearly much more efficient now than they were back then. Graham used to love buying his famous "net-net" stocks, companies that were selling for less than the value of their current assets minus all liabilities. With the increased level of market participation today, finding net-net stocks is all but impossible. Yet the markets are never completely efficient.
Graham and Dodd's central concept was to apply analytical rigor and effort in examining securities, then purchase those selling for less than their intrinsic worth. In general, as more participants enter the game, the supply of great businesses selling at cheap prices diminishes. Nonetheless, the behavior of market participants over the long term is quite predictable, and if you follow the following advice, you will do better than most investors:
Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful.
The above wisdom was laid down by Warren Buffett, who holds one of the best long-term investment records ever, compounding money at more than 20% for 40 years and counting. How does one follow this advice? By exploiting market opportunities where there is a high degree of fear or pessimism. Let's examine the most obvious market environment now, and I will follow up with a couple more in my next article.
General market pessimism
The most obvious fertile ground for picking up good companies cheap is during the height of bear markets, when fear and uncertainty run rampant. Back in 1974, after nearly two decades of stock price appreciation, the markets fell hard. Most people fled the equity markets, thus missing out on one of the century's best buying opportunities. It was around this time that Buffett began scooping up shares in Washington Post
A similar situation occurred from late 2002 into 2003, after the tech bubble: Dirty laundry was washed out and securities were cheap again, but everyone was afraid -- even though the gap between value and price was wider than it had been in a decade. Investors who are overcome by emotion always disregard market fundamentals, buying when they should be selling and vice versa.
Consider the year 1987, which was characterized by an enormous surge in share prices between January and August, followed by the crash in October. William Ruane and Richard Cuniff, chairman and president (respectively) of the hugely successful Sequoia Fund, remarked:
Disregarding for the moment whether the prevailing level of stock prices on January 1, 1987 was logical, we are certain that the value of American industry in the aggregate had not increased by 44% as of August 25. Similarly, it is highly unlikely that the value of American industry declined by 23% on a single day, October 19.
One of the worst days in the stock market just happened to be one of the best buying opportunities in the stock market.
Simple, but not easy
Buffett once said that investing was "simple but not easy." I take this to mean that investing is simple, in that all you need to do is wait for opportunities when Mr. Market is behaving erratically to buy or sell stocks, but not easy, in that most people prefer to buy on the way up and sell on the way down. Right now, most investors are gladly paying more than 50 times earnings for Google
I am not singling these businesses out to suggest my like or dislike for them specifically -- they were chosen arbitrarily. Yet the idea of paying excessively high multiples for a company that cannot grow at phenomenal rates indefinitely is a recipe for disaster and makes no sense to me. On the other hand, finding a great company in an out-of-favor industry currently frowned upon by Mr. Market is a thought that grabs my attention.
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Fool contributor Sham Gad is managing partner of the Gad Partners Fund, a value-centric private investment partnership modeled after the 1950s Buffett Partnerships. He has no positions in the companies mentioned. The Fool has a steady disclosure policy.