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Is It Time To Panic?

The past few weeks in the stock market have been harrowing enough to put fear into the most seasoned investor. Another 4% drop yesterday has put the S&P 500 over 16% down since the start of September. Panic begets panic, and the past week has seen an acceleration in sell-offs as more and more people move into perceived safe investments such as treasuries, whose yield has fallen to about half a percent (as more people move into them, interest yield declines). MagicDiligence's Top Buy portfolio has not been immune, falling even faster than the benchmark. What is an investor to do in this environment?

Let's all calm down and take a deep breath. Nearly all bad decisions are emotional ones, and panic and fear are emotional responses to the current situation. We want to look at this situation logically and rationally before deciding to horde our money under the mattress. The basic questions to answer are: what is causing the market to sell off at such alarming rates? Does the rate of decline reasonably reflect the economic problems going forward? And last, as long term investors with at least a 5 year horizon, are these problems likely to be long-lasting or even permanent?

What is causing the market to sell off at such alarming rates?

Clearly the cause is the turmoil in the financial markets. Exposure to bad mortgages has spread like a virus due to derivative securities and threatens a wide variety of firms (detailed MagicDiligence analysis here). A slew of massive financial firms have failed or been bought out, from Lehman Brothers to Merrill Lynch and more recently, traditional banks like Washington Mutual and Wachovia. In this environment, banks are leery about lending out money, especially to each other as it's difficult to know who to trust. Since many businesses rely on short-term loans to meet operating expenses such as inventory or payroll, the inability to secure them can lead to a major slowdown in business activity. It's like having your credit card frozen on you, without you doing anything wrong.

Does the rate of decline reasonably reflect the economic problems going forward?

A 20% selloff in the market should discount about the same reduction in earnings looking forward. So far, the data indicates it is a major overreaction to the actual circumstances. As this article demonstrates, bank lending has far from dried up, even after the collapse of Lehman and AIG. Business, Real Estate, and Consumer loan activity was actually up from August levels in September, and bank-to-bank loans were only marginally lower. The 3-month inter-bank lending rate, or LIBOR, is a shade over 4% today. A year ago it was well over 5% (5.2%, actually). Smaller, well-run regional banks have picked up business by stepping in and providing loans that poorly run larger banks are now shying away from.

In fact, I've heard little first hand data from any stock I follow about having difficulty securing credit. Granted, the majority of MagicDiligence Top Buys do not use debt as a primary financing avenue, but even the ones with a fair amount of debt reliance have not indicated any concerns related to it. Since the Magic Formula systematically avoids banks and insurance companies, it's perplexing to explain why stocks with no direct exposure to mortgage assets are being sold off at a faster rate than the overall market. The rate of this sell-off looks speculative at best.

Are these problems likely to be long-lasting or even permanent?

Wall Street is myopic. This is no secret. A 20% sell-off in September generally means that the Street expects a similar decline in earnings over the next 3-6 months. I think that this may not be so far off. It's reasonable to expect that companies may slow down growth spending as credit becomes more expensive to obtain (if it indeed is). Some adverse conditions may be long lasting. For example, firms that produced big profits by riding the housing boom are unlikely to duplicate those results in the near future.

However, MagicDiligence picks (and many Magic Formula stocks in general) have some counter factors that are not being considered. Many of these companies have large cash balances that they can tap to buy back stock at historically low prices, reducing share counts and propping up earnings per share until growth resumes. Most also have little or no debt, so a macro-economic squeeze on sales presents no long-term danger to financial health. Several truly great companies are selling at price-to-earnings ratios not seen in 2 decades. One of Warren Buffett's most revered quotes is "Be Fearful When Others Are Greedy and Greedy When Others Are Fearful". It may be tough to focus in the future in these kind of times, but the truth is that markets like this is where long-term fortunes are seeded.

In summary, this is a terrible time to sell and an attractive time to buy, especially if you are looking ahead several years. The current sell-off does seem overdone - the fear just is not matching up well with hard lending data. While this data will likely deteriorate some, there is no hard indication of the credit system being in a "freeze" as so many Wall Street blowhards have been saying. Historically, buying during major drops like this have resulted in big gains in relatively short periods of time. Don't forget that the government is stepping in, in a big way, which should soothe any fears of another Great Depression. MagicDiligence Top Buys are all companies with sustainable competitive advantages and strong financial health. They are not going out of business, and many also pay very attractive dividend yields at current prices. So get tough, keep investing, and know that those with courage today will be rewarded in the future.

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Posted by dansam on 2008-10-07 10:20:30


I agree completely with your analysis and although I'm eager to take advantage of some "beaten down" stocks, my preference would be to invest in something relatively conservative. I was thinking of buying PG, KFT, or something similar.

Unfortunately, these stocks don't appear to be suffering (which is not surprising as everyone rushes to safety). Do you have any Magic Formula stocks that might fit my bill?



Posted by cookedc on 2008-10-07 14:45:19


Well done and encouraging comments when the market is dropping by five percent per day. I have been pondering how bad the economic and financial situation really is and how much stocks should be dropping.

Many companies stock prices seem to be correcting far too much given the situation. Look at QXM for example. It should be benefitting from a new stock buyback authorization worth approximately 15% of the market cap, coupled with a trailing P/E of less than 2.

You state above, "In fact, I've heard little first hand data from any stock I follow about having difficulty securing credit." Does this mean that you are in contact with investor relations or financial officers of MagicDiligence companies? If not, this would be an excellent way to add value for MagicDiligence members. You never know what valuable insights you could obtain by a few phone calls. This wouldn't necessarily entail overstepping any financial disclosure laws. The insiders could merely point you in the direction of where to find relevant information.

In a similar vein of primary research, do you pose questions during quarterly conference calls for MagicDiligence companies?


Posted by Steve on 2008-10-07 15:25:17


Thanks. It's a pretty extraordinary time to be an investor. If you offered an investor some of today's prices on blue-chip, world class companies, they would not have believed it. And today people are selling at those prices. Remarkable. Emotion is a dangerous thing in investing.

I have contacted investor relations on a few occasions when I can't find a piece of data. Almost to an instance, if I can't find it in the SEC filings or CC transcripts, calling has not been helpful. That said, I will continue to do it when necessary.

The story with conference calls is similar. Small operations like MagicDiligence have difficulty getting in the queue with large and heavily followed firms. That said, if there is information I feel is necessary that is not disclosed, I will pose the question.

Most information you need to make good investment decisions is in the filings and commentary. Schloss once famously ridiculed investment houses that spent big sums of money sending analysts to meet with management.

Posted by daveoddy on 2008-10-08 06:29:36

So it seems to make sense that it's a great time to continue to buy into a MF portfolio, but is it also a good time to sell positions scheduled to close? Does it make sense to increase the hold time beyond a single year? Perhaps this rates a new article, but I'd be interested in what the experts think...

Posted by Steve on 2008-10-08 06:51:30

I think that sticking to the strategy is the most important thing. If you have a position up to sell, it's fine to hold it for another year if the stock is still in the MFI screen.

If it has dropped out, I would go ahead and sell and replace with a new MFI stock. It's the same money, but you are moving it into a more attractive position and also banking a tax gain. As long as you use a no-fee broker there is no transaction cost involved!

Posted by daveoddy on 2008-10-09 10:27:44

I guess my question is based on the book's premise that the market inaccurately values companies in a short-term basis but accurately in the long-term. The strategy is to buy stocks when they are undervalued and sell them when their true value is recognized. Given our current volatility, can we really still consider one year to be "long-enough" term for a stock's true value to be recognized by the market? In fact, given that the book describes successful performance on a three-to-five year basis, it was strange to me to hold for only one year.

This is probably just the mistaken perception of an inexperienced investor, so I'm interested to hear what others have to say...

Posted by Steve on 2008-10-10 10:04:25

I'm working on an article addressing the disparity in holding periods.

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