Conventional wisdom tells us that equity investing ought to be avoided in the current environment. Threats of a recession and further implosion in the credit markets suggest that the worst is still to come. That may very well be the case. But conventional wisdom is often loaded with lots of "conventional" and very little wisdom. Investors who fall prey to the current market volatility will suffer at the expense of those investors who view the current volatility as an opening to buy cheap.
A previous lesson
In the year 1987, an enormous surge in share prices occurred between January and August, which was then followed by the crash in October. Following the market crash, William Ruane and Richard Cunniff, 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. So far in 2008, the S&P is down about 10%. At this rate, market historians are calling this the worst start since 1950. The carnage has affected just about everyone. Whether or not we'll see further decline is anyone's guess and should not be of great importance in the big picture.
Instead, investors -- recognizing that shares of stocks represent fractional ownership stakes in businesses -- should only be concerned with the probability of any permanent impairment in the business. For most companies, 2008 has done nothing more than provide investors with ample opportunity to buy more of a good thing for less. We've seen Warren Buffett actively gobble up shares in Burlington Northern
Words of wisdom
Instead of fixating on media headlines that continue to sensationalize the demise of the equity markets, investors should focus on the actions and activities of the practitioners themselves. Mason Hawkins, a brilliant long-term investor who sometimes falls through the cracks because of his self-chosen low profile, has been playing the investing game for decades. The track record that he and his team have produced for the Longleaf Funds is one that would make any investor proud. His quarterly letters to the Longleaf investors are a must-read for any serious investor, and his year-end letter is no exception:
The fourth quarter volatility gave long-term investors terrific opportunities to pursue. Short-term, prices suffered ... While negative performance is frustrating, falling prices are not necessarily worrisome. As patient, long-term investors we know that as long as appraisals remain intact, returns should be delayed, not lost. In fact, the prescription for declining stocks often is to buy more.
While the short-term outlook is hazy at best, over a meaningful period of time, investors who have the discipline to stay the course and buy wonderful companies on the cheap will do well. Hawkins continues:
Our partners who focus on portfolio returns over the next decade will appreciate the tremendous opportunity that lower prices created... Stability will return at some point, although we have no idea of the timing. The uncertainty of what the next six months will look like has Wall Street in knots [emphasis added]. While we may appear stupid in the short run, our long-term time horizon and that of our partners gives us the luxury to act based on how businesses will look several years from now, not based on whether fear will grip markets next quarter.
You don't have to go back as far as 1987 to see history at work. Amazingly, when it comes to declining markets, the collective wisdom seems to be very short-sided. Investors like Hawkins welcome the current market because they have profited from them before:
This environment is not dissimilar to that of the fall of 2002, and as most of you remember, the aftermath in 2003 was particularly rewarding.
Always exercise discipline
While the market decline has opened up opportunities, due diligence must always be exercised. Mr. Market is irrational, but he's not dumb. Most "cheap" companies deserve to stay that way.
Look at Bank of America's