Value Investing 7: The Question of Timing

by: Philip Mause

By its very nature, value investing tends to be at odds with timing strategies or "technical analysis" which attempts to discern the twists and turns of the market. There is the famous value investing mantra that "in the short term the market is a voting mechanism; in the long term the market is a weighing mechanism." However, the events of the last 12 years(the 2000-01 crash, the 2008-09 crash, the flash crash, and the last few weeks) make it almost impossible for an investor to ignore timing considerations. In an account with any kind of margin, a mistake in timing can lead to a wipe out. Even in unmargined accounts, enormous amounts of money can be gained or lost depending on the timing of purchases and sales.

I am going to digress for a moment and describe a useful spectrum along which to organize the universe of possible investments. For want of a better phrase, I will call it the "Relevance of what other people think" spectrum. It works like this. For certain investments, it may become almost completely irrelevant what other people think because the fundamental value of the investment will be realized regardless of the market. At the other end of the spectrum, we have investments that are completely dependent upon what other people think in the sense that the only exit strategy for an investor is to sell his position to another investor, hopefully at a higher price (sometimes sarcastically described as the "greater fool" approach to investing).

It is hard to imagine but there are certain investments that provide the desired return to an investor regardless of what other people think. For example, imagine a bond about to mature but subject to a lively debate as to whether the debtor will actually pay off the principle. If an investor analyzes the situation and is confident that the bond will be repaid, he can buy the bond, weather the storm if market decides that there will be a default, and collect the principle in the short period of time to maturity. If the market has created a large discount to face value, such a contrarian investment may provide enormous returns. Similarly, if there is a merger about to close and there is a debate about its prospects, the investor who analyzes the situation correctly and decides that the merger will close will get paid off regardless of whether anyone agrees with him. To a degree, this is what happened in late 2008 in connection with the takeover of Annheuser-Busch (NYSE:BUD). Bonds in general tend to be more on this end of the spectrum. Many bondholders are happy to get their interest payments and be paid off at maturity and are not very concerned if, along the way, the market decides that the bond is risky and drives down the price.

At the other end of the spectrum are things like gold and collectibles, where there is really little or no way to extract value from the investment except by selling it to another investor. These investments are almost completely dependent on market sentiment.

Where do stocks fall in this spectrum? I think a great deal depends upon dividends. Dividend paying stocks will provide returns to investors regardless of market sentiment although a large decline in the price of such stocks can undermine the strategy of investors who count on being able to sell. Stocks that do not pay dividends(many of the Dot-Com stocks that got crushed in 2000) tend to be more on the gold-collectible end of the spectrum, providing an investor a return only if the position can be sold to another investor.

In a time of high volatility and when there is a major market decline, one strategy is to position oneself to invest in "bond-like" stocks or bonds themselves that have become undervalued. In 2008-09, there was a furious bond sell off and incredible bargains were available. There was not way to determine when the market would turn itself around but in the meantime there were opportunities to get a current yield of over 20% on relatively safe bonds which ultimately doubled or tripled in price as things normalized. One of my favorites was the debt of Allied Capital which has been taken over by Ares Capital (NASDAQ:ARCC) and carries the symbol AFC. These publicly traded bonds have a face value of $25 each but were trading below $6 in early 2009. One could examine the balance sheet of Allied Capital and be reasonably confident that even in a liquidation a bondholder would get a lot more than $6. As things stabilized, the bonds traded up; meanwhile an investor was earnings more than 25% on his original $6 investment.

Over the past two weeks, AFC has dipped below $19 and got to current yield levels of roughly 9%. I have followed a policy of buying whenever it goes below $19 although I know full well that $19 may not be the bottom.

I think that a similar strategy should be considered for dividend paying value stocks. An investor should familiarize himself with the stock and the company and develop a target price below which he has strong conviction that the stock is an incredible bargain in the long run. For example, such prices might be $25 for Microsoft (NASDAQ:MSFT), $48 for Wal-Mart (NYSE:WMT), $65 for Exxon (NYSE:XOM) and $20 for Intel (NASDAQ:INTC). Now here comes the hard part. When these stocks sink to these levels, it will feel absolutely horrible to go into the market and buy, All of an investor's fear-flight instincts will militate in the direction of selling rather than buying. None of these positions will pass the "will I sleep better at night?" investment test and, of course, the stocks may go down further. But some of the positions acquired this way will turn out in the long run to be the best decisions an investor has ever made.

The conservative approach is to focus on positions which are on the "it is irrelevant what other people think" end of the spectrum described above - bonds, preferred stocks, yield oriented stocks like BDCs, REITs, MLPs, and solid dividend paying blue chips. Of course, you should never exhaust your "dry powder" on one day or even in the course of one week or one month. But investors should have in mind a "nibble level" for stocks they are targeting and should start nibbling when the stock hits that level regardless of how bad it makes them feel.

Disclosure: I am long AFC, ARCC, XOM, MSFT, WMT, INTC.