How To Invest $1,400 (Or Less) At The Point Of Maximum Pessimism

|
Includes: ARP, ATLS, AZUR, CJES, CRK, CVO, GNK, HK, HNR, JGWE, KEG, QTM, STRI, VMEM
by: Manny Backus

Many great investors have explained the idea of maximum pessimism as one of the keys to investment success. Warren Buffett sums up this thought as being greedy when everyone else is fearful and being fearful when everyone is greedy. A member of the wealthy Rothschild family, owners of Europe's largest bank and greatest fortune in the nineteenth century, supposedly said the time to buy is when there is blood in the streets. Less eloquent investors have simply expressed the idea as "buy low, sell high."

This advice is all useful but vague. Many of wish we could invest like Buffett or duplicate the success of the Rothschilds, but there is nothing in their statements that tell us how to do that. Studying their lives, we learn little more. Buffett rarely provides specifics, into his thinking while the Rothschild family accumulated wealth by financing Europe's large wars, a feat that could never be duplicated.

To obtain specific advice we can follow, we can turn to Sir John Templeton, the great investor who advises us to "invest at the point of maximum pessimism."

Templeton was a noted value investor who began his career in 1936 with Fenner & Beane, one of the firms that would eventually become part of Merrill Lynch. Stocks were not popular investments in 1936, a time when the world was finally showing signs of recovering from the Great Depression. But Templeton was confident the market would recover and left Fenner & Beane to establish his own firm in 1937.

His confidence in the markets came from his time studying at Yale as an undergrad. Templeton had grown up poor, but many of his peers at the Ivy League school often came from wealthy families. Looking back at that time late in life, Templeton attributed his success in the markets to his observation that stock market investments funded the lifestyles of the wealthy students he met. He also thought of a way to outperform his peers:

"In Tennessee I didn't meet anybody who owned a share of anything. At Yale there were hundreds of boys from wealthy families, but not a single one who was investing outside one nation. I thought that was just not sensible. Surely they'd get better results if they searched everywhere rather than limiting their search to one country."

Templeton delivered large returns by applying his global investment strategy to international markets. As his firm grew in size, he turned his attention to mutual funds which offer economies of scale to investment managers. It can be less expensive to manage a mutual fund than it is to maintain thousands of individual accounts. His oldest fund, the Templeton Growth Fund, recorded an average annual gain of 13.8% while Sir John was involved in the operation from 1954 to 2004. The S&P 500 delivered an average annual return of 11.1% over that same time.

Over 50 years, a 2.7% difference in annual returns adds up to a tremendous difference in wealth. A $1,000 investment in Templeton's fund would have grown to $641,377 while that same $1,000 in the S&P 500 would have grown to $193,065.

2

While Templeton eventually applied his skills to foreign markets, he demonstrated his philosophy can be applied to U.S. stocks as well.

Shortly after Templeton started his firm, investor pessimism surged. In 1939, World War II began with Germany's invasion of Poland and stocks around the world fell. In New York, the Dow Jones Industrial Average fell almost 25% over five months. Sensing pessimism was at a maximum, Templeton bought $100 worth of stock in every company trading for less than $1 a share on the New York Stock Exchange. He purchased 104 companies for about $10,400. Four years later, his account balance topped $40,000 even though 34 companies had gone bankrupt. Templeton's investment generated an average annual return of 40% a year because he understood pessimism had created bargains.

This is a strategy that anyone can duplicate. It seems fair to say pessimism related to an individual company is at a maximum when a stock trading on the NYSE falls below $1 a share. NYSE rules require that a stock be trading above $4 in order to be listed on the exchange and exchange officials will usually take steps to delist stocks if they trade under $1 for an extended period of time. These stocks often move to the NASDAQ system where low-priced stocks are more commonly traded.

There are risks associated with this strategy. Some of the companies trading under $1 a share will go bankrupt. In Templeton's case, about one-third of the stocks went bankrupt. The gains he enjoyed resulted from the fact that many of the companies will rebound and reward investors. An example from more recent times demonstrates the size of the potential gains. In March 2009, Citigroup (NYSE:C) fell under $1 a share and has gained nearly 400% since then.

Today, just 14 companies pass Templeton's test of trading below $1 a share on the NYSE. These are companies trading at the point of maximum pessimism.

3

To duplicate Templeton's strategy, buy all 14 and then wait. Templeton usually gave a stock up to six years to deliver results. If it hadn't moved up much after six years, he would sell.

It should be possible to improve our odds somewhat by narrowing the list to stocks having high relative strength (RS) and are trading at a price below the value of the cash on their balance sheet. RS indicates the stock is outperforming other stocks in the market and is a sign of investor demand. Testing shows stocks with high RS tend to outperform the broad market over the next 3 to 12 months. Cash on the balance sheet should provide the company with the ability to continue operating. A lack of access to cash for short-term operations led to problems for many companies in 2008. Requiring a cash reserve for low-priced stocks is a way to reduce risk.

That leaves just one company that could be the best trade for conservative investors.

Comstock Resources, Inc. (NYSE:CRK) is an oil gas producer. Its oil and gas operations are primarily located in East Texas, Northern Louisiana and South Texas. The company owns interests in 1,575 producing oil and natural gas wells with proved reserves of 625 billion cubic feet of natural gas equivalent. CRK was founded in 1919 and has survived oil booms and busts for nearly a century.

At the end of last quarter, CRK had $1.47 in cash per share. Combined with cash flow from operations, this would be enough to finance operations for three quarters at the current rate. With energy prices firming, CRK seems to be bottoming.

More aggressive investors might want to follow Templeton's strategy and invest $100 in each of the 14 stocks. Smaller investors could invest $50 or even less given low commissions available at many brokers. Looking pessimistically into the future, if we assume one-third go bankrupt, half are unchanged and three stocks deliver gains of at least 100%, these buys would deliver a 30% return on investment.

Templeton's "under $1" strategy could be updated once a year and over time could allow investors to generate significant wealth by investing at the point of maximum pessimism.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.