Beating Your Paralysis in 3 Steps

Has the drop in equity prices left you with feelings of paralysis when it comes to managing your portfolio? That's normal, according to Jeremy Grantham; in fact, professional investors suffer from the very same feelings, which end up costing them lost returns. The good news is that you're not powerless: Grantham offers a way to deal with these feelings and take advantage of the current market environment.

Who cares what Jeremy Grantham says?
Grantham, the co-founder of GMO, an asset management firm with nearly $90 billion in assets under management, has been dismissively labeled a perma-bear for the last decade. The truth is that he is only pessimistic when his analysis of the environment warrants it -- and he has been prescient in calling the credit and Internet bubbles.

As conditions change -- and a massive drop in stock prices certainly qualifies – Grantham has turned from bear to bull on stocks. In his recent article 'Reinvesting When Terrified', he put the S&P 500's fair value at 900 -- 30% higher than when the article published (and still a few percentage points higher than current levels) with expected annual equity returns ranging from 10 to 13% -- after inflation! (That's substantially above the historical after-inflation average return on stock of 6.5%.). No wonder he recommends investors find the fortitude to take advantage of attractive equity prices before they succumb to "terminal paralysis" induced by the bear market.

Seize control of your portfolio through planned action
I recognize that it is difficult to contemplate buying stocks after a sustained period of falling equity prices. Even the occasional Geithner rally isn't helpful, as investors defer acting in the hope that the market will retest its lows. But Grantham has a cure for paralysis: 1) Accept that you will never catch the market bottom, 2) develop a battle plan to get back into the market, and 3) stick to it.

Grantham practices what he preaches, too:

This is what we have been doing at GMO. We made one very large reinvestment move in October, taking us to about half way between neutral and minimum equities, and we have a schedule for further moves contingent on future market declines.

Adopting a systematic plan of this kind is contingent on recognizing that stocks have an intrinsic value and being able to estimate it. As another value-oriented strategist, James Montier, wrote in a recent client note: "Valuation gives a good signal as to when to return to the markets. Buy when it's cheap. If not then, when?"

I've written about Montier before; he's not your garden-variety Wall Street strategist: In one note, he warned clients that "materialistic pursuits are not a path to sustainable happiness." (Heresy on Wall Street!)

Montier's rule
Montier suggests one possible rule for action, in which investors are invited to buy stocks when they are in the bottom quartile of historic valuations. This won't protect investors from price drops over a one-year timeframe (remember: don't try to catch the bottom – the perfect entry price is the enemy of the good entry price), but it gives good odds of reaping solid returns over longer periods.

Following Montier's cue, I performed a screen to find mid- and large-cap stocks trading at the bottom of their historical valuation range. I encountered one problem: The screen was drawing on valuation data that only goes back as far as January 1995. In order to mitigate that limitation, I searched for stocks with a current valuation in the bottom fifth percentile over the period beginning in 1995, instead of the bottom quartile.

(I also excluded financials: While it's quite clear that many of these stocks are trading near all-time valuation lows, they are facing a near unprecedented set of risks also.)

Good businesses trading at historically low valuations
It turns out that more than one in five stocks are within the bottom 5% of their historical valuations (measured by their price-to-tangible book value ratio). They include some superb businesses that dominate their industries, including:

Source: Standard & Poor's Capital IQ.

As you go through the table, you'll find that you've already missed out on 30%-plus returns in both Dow Chemical and Alcoa. Does that matter? No! What counts is being able to buy attractive businesses at a discount to their fair value.

Let me caution you that Montier's rule is almost certain to work if you implement it on a large enough set of stocks, but it could lead to disappointing results when it comes to any single stock. For that reason, the stocks in the table above aren't recommendations. It would be irresponsible on my part to recommend a stock on the basis of a single valuation metric.

The team at Motley Fool Inside Value compare stocks' valuation ratios against their historical range, but that's just a starting point. Performing discriminating quantitative and qualitative research, they weed out the genuine values from the statistical outliers (i.e., value traps). They can help you implement your investing plan with their 'Best Buys Now' -- the team's best recommendations for new money now. To find out their five current best values and beat back bear market paralysis, sign up for a 30-day free trial today.

Alex Dumortier, CFA has no beneficial interest in any of the companies mentioned in this article. Walt Disney and Pfizer are Motley Fool Inside Value selections. Walt Disney and FedEx are Motley Fool Stock Advisor recommendations. The Fool owns shares of Pfizer. The Motley Fool has a disclosure policy.