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On Tuesday’s Decline

After as memorable a market move as yesterday’s (made all the more memorable by the lack of such days over the past half decade), I would love to be able to write that you have nothing to be worried about. Many other bloggers have written as much and they’re right to do so. Despite the fireworks, nothing much has changed. If you were completely comfortable owning stocks on Monday you should be completely comfortable owning stocks today.

I’m comfortable with the stocks I own. I just wouldn’t be comfortable owning a representative sample of the overall market. I wouldn’t be comfortable owning the Dow or the S&P; 500, because they are trading at uncomfortable valuations.

I started this blog on Christmas Eve 2005 intending to publish a quarterly newsletter. After just two quarters, I had to close up shop for a very simple reason. During the third quarter of 2006, the trickle of good ideas slowed to the point where there was no longer something worth printing every quarter.

This blog is free. You can come and skim it as you like when you like. It’s a nice, casual arrangement that lets me write about interesting stocks without feeling like I’m holding any particular stock out as the absolute best opportunity of the moment. I’ve taken advantage of that – in fact, you may have noticed that during the second half of 2006 my posts on individual companies tended to end with more ambivalent conclusions. There’s a simple explanation: it has become much harder to find stocks I can write about with conviction.

At the end of last year, I started writing about the market in general. I presented my thoughts in a roundabout way through a series of posts on normalized P/E ratios. The most important of these posts was the one entitled “In Defense of Extraordinary Claims” which concluded with these words:

Stocks are not inherently attractive; they have often been attractive, because they have often been cheap. The great returns of the 20th century occurred under special circumstances – namely, low normalized P/E ratios. Today’s normalized P/E ratios are much, much higher. In other words, the special circumstances that allowed for great returns in equities during the 20th century no longer exist.

So, don’t use historical returns as a frame of reference when thinking about future returns – and do lower your expectations!

The long-term earnings growth rate of such a large group of big businesses simply can’t be all that fast. We can argue over whether earnings can grow 9% in any given year, but we know they won’t grow 9% in the long-run. That was the point behind my normalized P/E series. The idea that buying in at these levels will provide you with the kind of historical returns seen during the 20th century is absurd.

Stocks were a lot cheaper a lot more often than most people realize. Buying stocks at today’s prices may provide adequate returns and may be the …

20 Questions for John Bethel of Controlled Gree

John Bethel bought his first stock in 1986, and became devoted to value investing that same year after reading Warren Buffett’s “Superinvestors of Graham-and-Doddsville.” He became self-employed in 1994, and began investing all his own money at that time.

John writes Controlled Greed, a blog reporting his adventures as a stock picker. He personally owns every stock recommended on the site. Controlled Greed launched in April 2005; John’s reported stock picks have averaged +36.9% for the life of the blog through 2006. His stock picks averaged +27.5% for the year 2006 (both figures include dividends).

Visit Controlled Greed

1. Are you a value investor?

Yes.

2. What is value investing?

Stated simply, it’s buying a stock that’s trading for less than the underlying value of the company it represents. There may be different ways of measuring this, such as discounts to tangible book value or sum-of-the-parts analysis, among others, but that’s basically what it is.

3. What is your approach to investing?

I want to buy a company that’s undervalued, and that I can see a way or several potential ways for the value to be realized over the long term. Sometimes I get lucky and the stock price rises in several months, but my window upon buying is three to five years.

4. How do you evaluate a stock?

The process of finding a stock to invest in can take days or years. I start by reading, reading, and reading some more. I think you need to love reading generally to be a good value investor. My memory is that Warren Buffett told Charlie Rose on Rose’s PBS show that when he comes to the Berkshire Hathaway office every day he starts by reading newspapers, business magazines and annual reports. And that reading is the bulk of his job.

I also follow the holdings of some of my favorite investors. One of the things I like about Christopher Browne’s “The Little Book of Value Investing” is that he writes about this very approvingly. If the guys at Tweedy Browne are looking at what Peter Cundill, Mason Hawkins and Marty Whitman hold, and they’re all looking at each other’s portfolios, then it’s something you and I should be doing too. It’s a great way to build a list of candidates for investment.

That said, you shouldn’t buy a stock just because one of your favorite investors owns it. They may have bought it at a much lower price than what it’s going for once it’s reported, for one thing. And you still need to research it to make sure you understand it. Plus, many of the top-notch investors have portfolios with billions of dollars of assets — meaning they can’t take advantage of some smaller bargains.

Reading all this stuff as the years go by builds up a knowledge base. Sometimes I come across a story that makes sense, I research to confirm it, and make the stock purchase. Other times, it takes longer.

An example is …