Rick of Value Discipline wrote an excellent post yesterday entitled “Value Delusions and Strategic Thinking.” In my view, this post is an especially important read in today’s market environment. Whether current market wide valuations are reasonable or not, it seems clear that the supply of obvious bargains is relatively low.
It’s no secret that “value stocks” have outperformed in recent years. These are the conspicuously cheap stocks – the ones that knock you on the head and say “Look at my price-to-book ratio, look at my price-to-earnings ratio! Does it really matter what kind of business I am? I’m so cheap the only thing you need to know is that I can pay my bills on time.”
And sometimes that’s true. Sometimes, there’s a veritable feast of such conspicuously cheap stocks scattered across a variety of industries. By selecting a diverse group of stocks that share only their conspicuous cheapness and nothing else, an unimaginative investor can rack up solid returns during such times.
Today isn’t one of those times.
There are two kinds of unloved stocks: those that suffer from contempt and those that suffer from neglect. The greatest long-term advantage in hunting for bargains among small cap stocks doesn’t come from the companies themselves – rather, it comes from investors’ attitudes towards these smaller stocks. Since there are so many small stocks, most investors can’t help but neglect a great many of them. And so, there tend to be more bargains born of neglect among small cap stocks than among their larger brethren.
Try this little exercise when you get a chance. Start with a blank piece of paper. Then, write down the ticker symbols of the stocks you currently consider to be cheap. If you’re an unmovable bear, write down the ticker symbols of the stocks you consider to be cheap relative to the market. Treat this as a free write. Don’t linger on a particular stock or second guess yourself – the moment your hand stops moving, you’re done.
Now, go over the list and ask three questions of each stock. One, is this a bargain born of contempt or neglect? Two, is this stock cheap because of company specific concerns or because of industry wide concerns? Three, if this were a private business, would it be considered a great business, a good business, an average business, or a poor business? In other words, is this a strong player in a healthy, growing industry or an also ran in the buggy whip business?
Hopefully, your list will feature a good mix of businesses from a variety of different industries. Ideally, it will have some neglected names on it – truly special businesses that are being valued like they’re nothing special.
I recently performed this exercise myself. After the list was complete and I had gone back over it with the precise ratios in hand, I found the truly cheap businesses were not high quality names and were concentrated in a very few industries. …Read more