Beware When Bears Say 'This Time Is Different'

|
Includes: LQDT, PB
by: Terrier Investing

Summary

A recent article stated that "every rally should be viewed as a selling opportunity."

No. An overwhelming preponderance of data shows that individual investors sacrifice significant returns by attempting to time the market.

Smart investors view sell-offs as opportunities to purchase shares of high-quality businesses at a reasonable price.

"Especially during downdrafts, many investors impute intelligence to the market and look to it to tell them what's going on and what to do about it. This is one of the biggest mistakes you can make."

- Howard Marks

bear bull I am not a macro prognosticator, which is why I so enjoy poking at permabears when I get the chance. A recent article attempted to scare the bejeezus out of individual investors, stating that "every rally should be viewed as a selling opportunity."

Well, guess what? It's not the bulls saying "This time it's different." It's the bears. A month ago, I briefly discussed the history of the U.S. stock market, pointing out several reasons why investors should still own stocks, even though I agreed that indexes were expensive in general. (Personally, since I focus on individual securities - as we'll get to later - I couldn't care less what the market does.)

In hindsight, of course, it's easy to say that you would have been better off selling in December. So, over the last month, the permabears have won the battle - but they've lost the war, with no hope of ever recovering. The problem, of course, is that they've been calling for a crash since 2011.

I think times such as these are great for thinking about some of the bigger-picture factors in being an investor. Here are a few worth considering.

1: This Time It's Not Different

Perhaps the most important premise is this: Owning shares of American companies over the long haul has been a very, very good mechanism for wealth creation.

What is interesting about the current pullback is that it is divorced from fundamentals. While the U.S. is clearly in a manufacturing recession, other data doesn't suggest reason to panic - outside of energy, for example, there certainly aren't clear examples of rampant capital misallocation coming home to roost, like there were when the housing bubble burst.

One of the smartest investors around, Howard Marks, pointed this out cogently. Sophisticated investors know that Howard Marks' memos are always superb, but he's outdone himself with his latest. Go read it. Here's one of the relevant bits:

I set a trap at the beginning of this memo, and I want to spring it now. In the first paragraph, I wrote, "We've seen bad news and prices cascading downward." You probably glossed over it. But is it true? Leaving aside China and the markets' gyrations, have we really been seeing negative news on balance? Isn't it just that people are fixating on bad news, ignoring good news, and tending to interpret things negatively?

There are ways in which psychology can become "real," feeding back to influence fundamentals. One is that declining asset prices produce a negative "wealth effect," making people feel poorer and causing them to spend and invest less. And there are others. But despite the feedback influences of the market declines, I still would say U.S. and European economic fundamentals aren't negative on balance.

2: Behavioral Factors Overwhelm Rationality

If you're an individual investor, it sure sounds tempting to try and "time the market" - buy low, sell high, all that good stuff, right? The problem is, it's much easier said than done. If you do a little research, you'll find that an overwhelming amount of data - from Dalbar, from Vanguard, from really just about everyone - demonstrates that individual investors are better off sticking to a long-term buy-and-hold or rebalancing strategy than trying to time the market.

In fact, depending which study you look at, individual investors seem to sacrifice more than 2% of annual returns (and often much more) by trying to time the market. This may not sound like a lot, but over time, that adds up - and in many cases, it can be even worse. As two anecdotal examples, my father and a close family friend both sold roughly half of their equity holdings near the March 2009 bottom and didn't repurchase until 2012-2013.

As Marks wisely puts it, "In my experience, most people who are lucky enough to sell something before it goes down get so busy patting themselves on the back that they forget to buy it back."

From a portfolio perspective, there are numerous "systematic" ways to avoid this sort of emotionally driven fear - dollar-cost averaging, holding some cash or short-term bonds and rebalancing on a quarterly or annual basis, etc.

For those who are interested in taking a more involved approach, I am writing a weekly column, "Value Investing Weekly", that explores how behavioral economics and psychology interact with classic value investing principles. As I discussed in the first post, the best way to be a successful investor is to figure out what strategy you're well suited to stick to over time - and then to do so. As I discussed in the second post, confirmation bias can be very damaging to returns - and in fact, this is the exact problem that plagues permabears. As Marks points out in the memo, right now the market is choosing to focus only on the negatives and not on the positives. A small community of thoughtful investors are already regularly interacting in the comment stream of Value Investing Weekly to promote deeper understanding of these issues, and I invite you to join them.

3: It's A Market Of Stocks, Not A Stock Market

A final point investors would do well to consider is that while macro headlines may dominate the newspapers, the truth is that a share of stock represents an ownership stake in a real business. At its core, the simplest form of investing is about buying good businesses at reasonable prices. If you get those two variables right, everything else will take care of itself in the end. It always amuses me that the first thing people ask me when they learn I'm a professional investor is "Oh, what do you think about the market?" My response is very Gone With The Wind - Frankly, my dear, I don't give a damn.

As Marks discusses extensively in the memo, during sell-offs, panic can drive shares of individual securities (or even whole classes of securities) down to levels that are completely unjustified by the fundamentals. If you're smart, this should be viewed as an opportunity rather than a threat. Here are two examples of stocks I'm buying right now that have been irrationally sold off, although they're by no means the only ones.

The first is Prosperity Bancshares (NYSE:PB), a Texas-based bank. Pretty much all Texas banks are being sold off in a basket due to fears of energy credit quality. To some extent, these fears are valid - there's been a lot of skunky lending in energy. That said, I would point out that the Texas economy is highly diversified, and Manhattan analysts who worry about severe follow-on effects to the economy are clueless - this isn't the '80s.

Nonetheless, Prosperity is the proverbial baby getting thrown out with the bathwater. The bank's underwriting standards are phenomenal (see the credit performance through '08-'09). Management has the vast majority of their own net worth invested in the bank, and they've been Texas bankers for multiple decades through multiple oil cycles. In fact, if I remember the story right, Prosperity was founded during an oil bust.

To give you an idea of how absurd the depth of the sell-off in the stock is: Prosperity's loan portfolio totals about ~$9.2 billion (with a slightly larger amount in securities). Of this, under $460 million was in energy as of last quarter. Even if half of these loans were written to zero, and none were already reserved for - a hugely punitive, apocalypse-type scenario - that would represent losses of, say, $230 million, or roughly 15% of the bank's tangible equity of $1.53 billion. Moreover, this one-time loss would be more than offset by the bank's annual net income.

In a more realistic scenario, the bank estimated in October that it could see up to $15 million in losses on energy credits. Since conditions have worsened since then, even if you double or triple this figure for the sake of conservatism, it would be a one-time hit that would represent about half of one quarter's earnings.

So, even if you believe that things will get really bad, you're looking at a one-time loss of, say, a couple bucks per share in value, versus a sell-off since the beginning of January of something in the neighborhood of $13 per share.

Does that seem rational to you?

Not even close. I discuss Prosperity in more depth here, but I've viewed the recent market panic as an opportunity to pick up shares of a high-quality long-term compounder at a deep discount.

Another example is Liquidity Services (NASDAQ:LQDT), a company which is quietly transforming how the liquidation industry functions. Since I wrote up a 2,500-word article on it here, I won't spill too much ink here other than to say that 70% of the market cap is in cash, founder-CEO Bill Angrick is a visionary, the company has long-term opportunity for double-digit growth, and after extensive research over multiple years, I've seen fit to size the position at a level that gives Berkowitz and Buffett a run for their money on American International Group (NYSE:AIG)/American Express (NYSE:AXP). I believe it to be an extremely compelling opportunity, with downside risk significantly mitigated by the fortress balance sheet, and the potential for 50% annual returns over the next three years.

Wrapping It Up

Owning shares in American companies, whether through an index or individual shares (my preferred method), is likely one of the best long-term opportunities for wealth creation to be found. Sell-offs like the current one can be scary - but in this case, there doesn't appear to be any fundamental economic weakness domestically, outside of energy/manufacturing. Sure, prices could go down farther, but I'm finding plenty of opportunities to deploy capital at attractive prospective rates of return.

While it's tempting to believe you're smart enough to time the market, the truth is that the subset of people who do this successfully is several orders of magnitude lower than the number of people who think they can. A large deal of statistical data demonstrates that individual investors lose out when they try to time the market. So turn off CNBC and take a deep breath. Things will be okay. Add a little bit to your investments every quarter, or every year, and you'll be better off in the long run.

Disclaimer: Investing is inherently subjective and this article expresses opinions. Any investment involves substantial risks, including the complete loss of capital. Any forecasts or estimates are for illustrative purpose only. Use of this opinion is at your own risk and proper due diligence should be done prior to making any investment decision. Positions in securities mentioned are disclosed; however, the author may continue to transact in any securities without further disclosure.

This is not an offer to sell or a solicitation of an offer to buy any security. All expressions of opinion are subject to change without notice and the author does not undertake to update or supplement this piece or any of the information contained herein. All the information presented is presented "as is," without warranty of any kind. The author makes no representation, express or implied, as to the accuracy, timeliness, or completeness of any such information or with regard to the results to be obtained from its use.

Disclosure: I am/we are long LQDT, PB.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.