The Greatest Risk in Today's Market: 'Settling'

by: Geoff Gannon

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. Just as troubling, the businesses I really did like were trading at a considerable premium to the businesses I didn't like.

A great investment opportunity shouldn't have to pass a checklist without a single black mark, because it isn't the number of the deficiencies that matters – it's the weight of the deficiencies that matters. Still, a great investment opportunity should provide absolute comfort, not merely relative comfort.

The greatest risk in today's market is the risk of settling. While poor businesses may be attractive at some price and quality businesses may be attractive at some considerably higher price, an investor needs to have a clear intellectual and emotional awareness of what the price is and what the merchandise is.

There's a danger that otherwise intelligent investors will relax their standards or allow themselves to be blissfully ignorant of "price creep" – where a business that once would have been a bargain at six times earnings now begins to look attractive at 10 or 11 times earnings, even if it isn't the kind of business you really want to be in. The desire to cast a wider net when confronted with a scarcity of the fish you know is natural; it's also dangerous.

That kind of complacency – an unthinking willingness to embrace a new normal is the greatest threat facing investors today. As is so often the case, it is necessary to battle the enemy within. It is necessary to step back, take a deep breath, and ask yourself what you're doing. What exactly are you buying and why are you buying it?

Spend some time alone with that stock – with that business – and then ask yourself if it still looks quite as pretty as it did when it was out there with all its friends.