I had a prospective client ask me the other day how we were handling the current stock market rally. He wanted to know if we planned on raising cash as the rally progressed or whether we thought this was the start of a new bull market. My prospect's question certainly isn't unusual. In fact, CNBC and the other popular media outlets spend hours debating those same questions. Speculating on where the stock market is going, what interest rates will do, whether commodity prices will rise once again this year - these are the questions to which people want answers. And, Wall Street provides those answers in abundance, although many of the answers contradict one another and most of the answers turn out to be wrong - predictable once you realize that it is all just speculation about an unknowable future.
Yet most individuals are so indoctrinated into the Wall Street mindset of prediction that they view it as a normal part of investing. Buy a stock because it may go up in the next six to twelve months - that's what the typical mutual fund manager tries to do. Look at ways to predict that a stock will rise in the short term - for surely six to twelve months is the short term. Upside earnings surprises, stock price momentum, rising earnings estimates, beating revenue forecasts - all designed to capture a short term stock price move. The problem? Not much in the way of business valuation gets done by the majority of investors, which is the core of any true investment methodology. Successful investors buy businesses for less than they are worth and sell them for more than they are worth. Business valuation is the core and price paid is the THE key.
I did answer my prospects questions. After all, I have just as much fun as the next guy trying to predict what the economy and the stock market will do next. It's fun, fascinating and endlessly entertaining, but I don't forget for one instant that it is still speculation and I make very sure to use my forecasts only as a backdrop for our core investing discipline in order to help us with risk management. For the record, I don't think this is the start of a new bull market; the economy is not yet on the mend, despite all of the cheer leading now emanating from the government and the talking heads on the Street. As well, any expansion is likely to be short lived once the economy does begin to respond to the massive fiscal and monetary stimulus that has been applied. The United States has simply taken on too much debt and has an insufficient ability to earn enough to pay it off. In short, the economy will continue to founder for years (perhaps decades) under the weight of the ever growing mountain of debt our government and corporate America have assumed.
Enough of the macroeconomics though. Now I want to answer my prospects question on how we are handling the current rally in the hope of passing along something useful to you.
We buy businesses when they are selling for substantially less than what we think a knowledgeable third party would pay for the entire business in an arm's length transaction. Bear markets create plenty of opportunities to buy good companies for great prices and great companies for good prices. We are currently buying hand over fist because we are finding plenty of bargains. Conversely, bull markets make for far fewer opportunities to make great investments, which means we will often end up holding cash toward the end of a bull market because we can't find a worthwhile investment.
We do adjust our buy discipline for macroeconomic factors. It was obvious to us in late 2007 and early 2008 that the financial sector was toast. The red flags were everywhere. We will not buy a business at any price if we don't think the business is viable, which means the balance sheet must be strong enough to allow a company to survive. The banking system is currently insolvent as a whole and the rules of the game change daily as the government attempts to salvage it - we will not buy into the banks at any price right now.
Likewise, we adjust our sell discipline for macroeconomic factors. During the great secular bull market of the 1990s it was reasonable to hold businesses longer than we normally would as the bull market pushed valuations further than justified. Rather than selling a business as it returned to fair value, we commonly held them a bit longer if the chart indicated that the uptrend was intact. However, price risk is not something you want to take during a secular bear market, which means we are currently much more aggressive selling investments as the market pushes them back near fair value.
And that is how we're handling the current rally. We are aggressively buying good businesses at great prices and great businesses at good prices but with the expectation of selling them as they approach fair value because we do not think that the next great bull market is anywhere close at hand.
