Is This a Permanent or Temporary Loss of Capital?

Congress learned from the Great Depression that allowing banks to enter the investment business risked destabilizing them. In 1933, the Glass-Steagall Act prohibited bank holding companies from owning other types of financial services, asking banks to stick to banking business only. But 66 years later the lesson was forgotten, and in 1999 this provision was repealed. As the saying goes, if you give a mouse a cookie, he’s going to want a glass of milk.

Commercial banks, investment banks, insurance companies and brokerages started offering each other’s services. This may or may not have introduced unavoidable conflicts of interest, but it certainly introduced an unmanageable level of complexity in financial services. Exhibits A, B, C & D: the failure of Bear Stearns, rescue of Fannie Mae (FNM), Freddie Mac (FRE) and AIG (AIG), rushed sale of Merrill Lynch (MER), and bankruptcy of Lehman Brothers (LEHMQ.PK). We could use more of the alphabet for examples, but you get the picture.

On Monday, September 15, 2008, the U.S. stock market had its worst day since the terrorist attacks of 2001. Panicked by the bankruptcy of Lehman Brothers and the emergency sale of Merrill Lynch, U.S. markets convulsed and international markets followed. During times like these, individual investors often make critical mistakes because they do not distinguish a permanent loss of capital from a temporary loss of capital.

Permanent loss of capital is no trivial matter, as Lehman Brothers shareholders know well. When a public company fails, the value disappears and the owners’ losses cannot be recouped. But thousands of perfectly healthy companies also lost value on September 15, and it’s important to understand that most of those losses are temporary. Under duress, many investors simply pull their money from “the market” without consideration of the individual companies that make up the market.

Before we ask why oil and pharmaceutical companies get dragged down by failures in the financial services sector, let us consider a curious anomaly of the market’s sudden drop: every company in the Dow Jones Industrial Average lost value on September 15, except one. One Dow component’s price actually rose while everything around it was tumbling. Why?

Coca Cola (KO) is in many ways a poster child for conservative investing. Cautious investors prefer companies with solid fundamentals such as profits and cash flow, a margin of safety afforded by liquid or nearly liquid assets and strong market positioning, and reliable long-term prospects.

Coca Cola is the kind of company investors flock to when the market gets too scary for them; it’s called the “flight to quality,” as if “quality” only has value as a retreat.

Coca-Cola does not appear to be extremely cheap, or unlevered, but investors are confident that Coke will remain solvent and in business. Investors seem confident that Coke will be selling soft drinks in 10, 25, 50 years. Likewise, although it dipped on September 15, Johnson and Johnson (JNJ) is flirting with its all-time high.

click to enlarge

[Editor's note: The original version of this chart contained faulty data. It has since been corrected.]

Although the credit crunch, large bank failures and government intervention of 2008 are indeed unprecedented, the stock market itself has been through many periods of sudden volatility. In just the last decade, the markets experienced several dramatic dips. Likewise, strong companies like Johnson & Johnson experienced periodic dips, but entrepreneurial investors keep an eye on the long-term trend. "The Market" may be very volatile - the S&P 500 lost over 4% on September 17, 2008, and then gained over 4% on the next day - but ultimately investors reward (and are rewarded by) profitable companies.

Let us once again quote Benjamin Graham, the “father of value investing,” who said, “In the short run the market is a voting machine, but in the long run it is a weighing machine.” Market volatility results from popular opinion, but eventually the market rewards profitable companies. “Eventually” requires long-term thinking, and long-term thinking prevents investors from turning temporary loss of capital into permanent loss of capital.

Keeping One’s Powder Dry

Stock prices rise and fall – the market fluctuates. When the drops are small, people seem able to maintain perspective on the temporary nature of such losses. Some people brag when their stocks have a good day, insisting that they made a lot of money. While both the losses and the gains are real, in another sense you haven’t made or lost money until you sell the stock. And that’s how overreaction turns temporary losses into permanent losses.

Certain financial companies are in desperate straits indeed, and there is a real ripple effect for every company that depends on credit. But this is why entrepreneurial investors focus on individual companies rather than on “the market.”

Throughout the current market turmoil, pharmaceutical and oil company stocks have been dropping. Do you think the market for pharmaceuticals is shrinking? Is oil now plentiful and cheap? Oil consumption in the U.S. has dropped slightly, and a slowing economy definitely affects consumption, but do you think demand for oil in China and India is dropping? And even if a slowing economy does reduce oil consumption worldwide, do you believe such a slowdown is permanent? Interestingly, because the price of oil rose so quickly over the last two years, the fundamentals for many oil exploration and development companies are still based on even lower oil prices than analysts are forecasting in the future.

Not every American invests in the stock market, but nearly every American has seen the film, It’s a Wonderful Life. The movie offers a powerful lesson in economics as Savings & Loan Chairman George Bailey tries to calm panicked customers during a bank run in 1929. His competitor, Mr. Potter, offers to buy the savings and loan shares at fifty cents on the dollar, and many of Bailey’s customers are ready to sell. But George gets their attention: “Don’t you see what’s happening here? Potter’s not selling, he’s buying!” Bailey’s Savings & Loan had real assets – the homes of his customers – and Potter wanted to buy them on sale. He understood the difference between permanent loss of capital and temporary loss of capital.

That’s why liquidity is important to entrepreneurial investors – it’s a way to “keep our powder dry” for emergencies. For people with cash reserves (dry powder), how bad a day was 9/15? Long-term investors were hunting for bargains to buy, not selling good companies cheap.

Comments

[WEBISKING:]

This man speaks the truth who wrote this article,Time will prove thatThis deal will be profitable the SMARTEST FINANCE GUY Buffett said it will MAKE the TAXPAYERS MONEY, Those who bought Ko at 49.99 MO at 19.72 and Pm at 49.50 this week will EASILY make double digit annual returns DESPITE all this doom and gloom .Be greedy when others are fearful and BUY QUALITY at discount prices

2008 Sep 28 09:22 AM

[pennystocks...:]

Interesting chart. I never realized that JNJ was lagging the S&P 500 by such a large margin.

2008 Sep 28 09:25 AM

[JCC:]

Most of the regulation created during the Great Depression was eliminated starting in the 70's. I think that we are on an 80 year cycle to repeat. We will have new or replacement regulation as a result of this debacle. About 80 years from now most will have been undone in the name of free markets and we will have another calamity.

2008 Sep 28 10:04 AM

[Jimbo:]

I concur with the author's opinion and conclusion. My wife and I own only one bank( a small regional one). My philosophy is to pay most attention to the stock, not the stock market. If the fundamentals of a stock are sound, don't cut and run. Even conservative investments such as electric utilities seem to have a certain amount of "hot" money which moves in or out on the first hint of any kind. This seems to me to be plain stupid. I do think JCC is correct. I remember thinking when Glass-Steagall was repealed that it was a big mistake. Phil Gramm may be culpable for this situation. The market seems to develop Alzheimer's after so many years.

2008 Sep 28 10:56 AM

[JeffWhit:]

Buying stable companies is all fine and good. But what if the overall market fundamentals deteriorate?

The "rescue" of AIG and others basically means printing more money. That, mixed with the ever increasing oil prices--radiating out to everything else, is basically inflationary. But it's not the good type of inflation, based on an over heated economy and only needing a fed rate hike and a bit of taxation to reduce the fire.

The interest rates have been lowered in a desperate attempt to even keep the market afloat. No matter who wins the election the trend is always to "let the chips fall" the first two years of any term such that a recovery can be touted during the last two. But this trend was predicated on a history whereby the USA held sway over global markets with the power of it's dollar. Something now to be devalued as the peso of years past.

So on the one hand we have the worst type of inflationary pressure, and on the other the federal reserve desperately lowering the OFFICIAL interest rate to keep the boat afloat. But the inflationary pressure is real and eventually the government will have to save itself by offering returns on it's bonds to match the real inflationary reality.

Images of a lifeguard pulled under by the would be rescued drowning victim come to mind.

2008 Sep 28 02:32 PM

[GZ:]

Chart legend is reversed. Sorry about that. Z

2008 Sep 28 06:14 PM

[Muzie:]

And so again careless bottom catchers are burned for believing stock markets always go up.

Perhaps Mr. Helfert can recycle this article. He'll just need to correct one sentence as follows:

"On Monday, September 15, 2008, the U.S. stock market had its worst day since the terrorist attacks of 2001."

change to :

"On Monday, September 29, 2008, the U.S. stock market had its worst day since the market crash of 1987."

There is some merit to Mr. Helfert's ideas, but one does not cross the train track when the train siren is still blowing.

2008 Sep 29 10:20 PM