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The Strategy That Makes Sense Right Now

By Chuck Saletta - Updated Nov 11, 2016 at 4:50PM

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Channel Benjamin Graham to find stocks in today's market.

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.

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Stocks Mentioned

American Express Company Stock Quote
American Express Company
AXP
$162.01 (2.02%) $3.21
Caterpillar Inc. Stock Quote
Caterpillar Inc.
CAT
$190.93 (2.63%) $4.90
Pfizer Inc. Stock Quote
Pfizer Inc.
PFE
$49.41 (-0.73%) $0.36
UnitedHealth Group Incorporated Stock Quote
UnitedHealth Group Incorporated
UNH
$536.87 (-0.07%) $0.39
Johnson Controls International plc Stock Quote
Johnson Controls International plc
JCI
$55.68 (2.90%) $1.57
Nucor Corporation Stock Quote
Nucor Corporation
NUE
$141.53 (2.12%) $2.94
Marathon Oil Corporation Stock Quote
Marathon Oil Corporation
MRO
$22.42 (2.10%) $0.46

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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