by Ben Claremon | Research Analyst
All European banks are insolvent!
Germany is going to leave the Euro!
The US is going to default on its debt obligations!
Any investor who has spent time trolling the internet—especially the blogosphere—or listening to talking heads on TV has likely been exposed to similar alarmist statements. In these strange times it is not even hard to find people who think that buying guns, gold coins and canned food is the best capital allocation strategy. Even slightly less extreme prognosticators do not hesitate to point out the risk that a number of severe events could cause a meaningful deterioration in the quality of life in the Western world. With so much volatility in markets and the constant barrage of negative media headlines, who can blame investors for being confused and potentially even a little bit scared?
Fortunately, it is during times like these when value investors can thrive. Any number of investment platitudes comes to mind but the most appropriate in this case surrounds the importance of being greedy when others are fearful, a philosophy espoused by both Ben Graham and Warren Buffett. Easier said than done, you say? Believe me, I know it is. Despite being a relatively young analyst, this sadly is not my first financial crisis rodeo. The first firm I ever worked for began investing for clients in September of 2007, just before the S&P 500 index hit its all-time high of around 1560. In retrospect, this was a terrible time to launch a hedge fund as the S&P 500 proceeded to fall to the devilishly low trough of 666 in March of 2009. Along that painful journey there were a number of periods in which the markets plummeted, then rallied and then went into free fall once again. Every day the news seemed to get worse and consequently it was hard to imagine a way to escape the downward spiral.
As someone brand new to the professional investment world, it was very difficult to maintain a contrarian stance. However, I know I was not alone. Specifically, the emerging field of behavioral finance warns investors not to fall prey to the confirmation bias in which people primarily seek out data that confirms their point of view and actively avoid dis-confirming information. The danger for investors, of course, is that they become so convinced that their position is correct that they are unable to see inflection points. This can happen on the way up or on the way down. History has proven that both bubbles and crashes reverse themselves at some point and that investing at turning points can be quite profitable. Correspondingly, it is a tenet of value investing that there are no bad stocks (ignoring fraudulent companies for the moment), only bad prices. In other words, savvy investors have a price in mind at which they would buy and sell a security and are keenly aware that valuation and margin of safety are the prime determinants of investment success.
This brings me to the main point of this piece. During the depths of the financial crisis—when everyone thought some of the major US banks were going to be nationalized and the investment banks were going bankrupt—I was working for a financials-focused fund. If anyone should have known that the prices of US financial institutions reflected the highly unlikely reality that the entire financial sector was insolvent, it should have been me. However, at that point in my career I spent too much time reading the near-apocalyptic predictions on sites such as Zero Hedge and was not focused enough on how cheap financial stocks had become. Let me just say that I don’t have anything against Zero Hedge. In my former life I was a contributor to that site and actually appreciate a lot of the research performed by the army of anonymous analysts. However, in early 2009 Zero Hedge and other sites like it failed to recognize that stocks had bottomed at egregiously low valuations. In fact, it was precisely in March and February of 2009 that the most dire predictions were being thrown with reckless abandon.
Eventually, the purveyors of doom and gloom were proven wrong and investors who believed that dipping their toes into the equity markets was too risky missed the buying opportunity of a lifetime. In fact, despite the very recent decline, from the low of 666 the S&P 500 has climbed all the way back up over 1100. Could the market have continued to fall? Could the entire global financial system have collapsed? Of course. But the truth at the time was that US companies and markets had survived two world wars, the Great Depression, the stagflationary 1970s, the Cold War, the S&L crisis and the bursting of the technology bubble. While a major day of reckoning was certainly possible, such a cataclysmic event was only one outcome of many. Plus, the fact that stocks had become so inexpensive seemingly provided the requisite a margin of safety to protect against the multitude of risks present at the time.
Right now we face no less uncertain times and people can be forgiven for being nervous, especially given how far and how fast global stock markets crashed not so long ago. But, we must remember that stock prices have no memory and what happened last time may not happen again. We all recall and fear the last crisis so acutely because of what is known as the recency effect, another common behavioral bias. With all of this in mind, the members of the Cove Street team are trying to remain nimble and focus only on individual security selection. We remain cognizant of the risks but know enough to let market valuations determine our investment stance. In reality, we welcome volatility and hope that once again the stocks of world-class companies fall to levels that discount a future that we believe is highly unlikely.
