How to Find Killer Stocks Amongst the Carnage

We were running Opium between seven Asian Ports in our stock market game and business was GOOD!

Hong Kong was our home base, Shanghai, Nagasaki, Saigon, Manila, Singapore, and Batavia (Batavia is the old Dutch name for present-day Jakarta).

But more on that later…

 

When in doubt LOOK don’t READ.

 

Figure 1 – S&P500 weekly chart in down channel

 

 
The weekly S&P500 chart is indicating the market is making lower highs and lower lows. Whether we believe it or not, the market trend has changed decisively from up to down until further notice.

Certainly the courage of our convictions will be challenged by a spectacular short covering rally, but don’t’ be deceived, we are in correction mode at best or a dreaded bear market at worst.

 

It might be time to dust off the ‘ol value playbook.

 

In our experience with bear markets, two rules to abide by are:

1. The leaders of the previous bull market tend to revert to the mean and;
2. The leaders of the next bull market are seldom the same as the prior bull market

Hence our playbook:

• Raise additional cash on rallies and to reduce our exposure to growth which has been running hard since the ’09 bottom.
• Maintain dry powder to put to work during capitulation selling.
• Refresh our faded memory on the laws of value investing which could be the locale for the next bull market.

How I became a Value Investor

 

When I was young – during the mid-80s – I grew up in a house where my father was a radio amateur aka. Ham Radio.

We had a monstrous antennae poking into the sky, attracting attention, while the country (South Africa) was in lock down due to a state of emergency and under a total media blackout.

We were the Rebel Radio broadcasting out in the dark of night … well not quite.

But seriously, we could have been confused for an espionage ring … KGB? CIA? Mossad?

As a result we were technologically advanced for the time and had this most amazing machine called the Apple II computer – remember this beauty?

 

 

 

 

I used to exchange games with friends on a disc we used to call a FLOPPY ha ha!

I believe 2 games in particular stood out on my path to value investing:

 

The Stock Market Game

 

One game I remember well went by the original name of – The Stock Market Game.

Essentially it was a random number generator which created random stock movements for one hundred securities either to go up or down.

I found it intriguing!

Then I discovered its one fatal FLAW

The code behind the game would never eliminate a security totally. If a stock went to 1c it would sit there for a few turns, which equated to months, then resume an upward random march.

So I Beat the stock market game.

I would buy every stock that traded at 1 cent – load up and wait.

Invariably if it wasn’t going out of business it would ultimately go up!

Now I can see you rolling your eyes here and saying well d’oh Greg that’s a game and not real life.

Yes, I would agree but I also found that style and simplicity of investing in beaten down issues intriguing.

It got me thinking about deep value – and my affinity for it.

 

Taipan!

 

Now here was a killer game if ever there was one.

 

This description from Wikipedia allowed me to relive my glory days as the Taipan!

“The basic strategy of the game is to buy goods (opium, silk, arms, and general cargo) at a low price and sell them at a higher price.  Opium is special in that it can be confiscated at random points by the local authorities, resulting in a fine for the player. This makes dealing in opium riskier however, it is also in general the most profitable item for trade.

The player may trade at any of seven ports: Hong Kong, Shanghai, Nagasaki, Saigon, Manila, Singapore, and Batavia (Batavia is the old Dutch name for present-day Jakarta). The port at Hong Kong is the player’s home port. Here the player has access to ship repair, a money lender, and a bank. Often in Hong Kong, the local extortionist Li Yuen asks if you would like to “donate” money to the Sea Goddess. If the player refuses to donate, Li Yuen eventually sends a fleet of hostile ships (which are much more difficult to fight than ordinary pirates).

The player also has the option of borrowing money from Elder Brother Wu, the moneylender. Goods may be stored in the warehouse in Hong Kong, while waiting for prices to rise. However, purchases left in the warehouse may be stolen if left too long. Rates of theft are higher with higher-end commodities such as opium or silk.

Note: A bug in the game allows the player to overpay the moneylender, acquiring “negative debt”. This “negative debt” will accumulate interest very quickly, and will count towards the player’s net worth.”

 

 

Aaaahhh memories of a well spent youth!

 

At this point the reader may be thinking I had an affinity for trading and/or spotting computer bugs! Either way, I consider the discipline of focusing on dislocations, where the ‘laws’ of investing often break, an important characteristic of value investing.

 

The final nail in my value investing education came years later when I picked up a book of Piggy Banks on the cover called Contrarian Investing – which can be yours at Amazon for $0.01 for a used copy — VALUE!!

 

 

 

What I like about Contrarian Investor and have used successfully for decades is the simplicity of finding deep value stocks (reminding me of the aforementioned stock market game) and constructing a diversified portfolio.

Once again, reinforcing my belief that investing is not rocket science but merely a set of rules executed with discipline and perseverance.

Without giving away the crown jewels (you can do that for 1c by buying the book at Amazon or reading the reviews at Amazon), you can identify a value stock by initially screening for stocks that are down more than 50%. Then apply some simple fundamental metrics such as:

• Price : Earnings ratio (prior twelve months) < 13
• Price : Book value < 1
• Price: Sales < 1
• Price : Free Cash Flow < 10
• A stock should pass on 2 or 3 of the above fundamental ratios. Scoring on all four may indicate extreme weakness and a solvency issue.
• Insider buying > $125,000 in last 6 months (GS: probably have to increase that amount due to inflation since book was published in 1999) – this alone qualifies as a purchase and allows for technology stocks that often don’t meet the above fundamental metrics.
• Diversify your portfolio over 12 or more securities that don’t reflect the same industry/sector.
• Limit portfolio to 20% per theme
• And some money management techniques – when to sell – v.important!

Let me emphasis, to buy what others don’t want is HARD. Books and a stock market game can give you all the rules you like but unless they mesh with your inner money blueprint (behavior psychology) you won’t be able to stick with them when they go wrong. And in investing EVERY style falls in and out of favor at some point in time.

 

The downside of being a value investor

 

On Friday the 12^th of February 2016 the market made a weekly close at 1864,78, below the August 2015 low of 1867. Hardly dramatic, but enough in our books, to confirm a downward trend is in force. Given that the average bear market since 1954 has been about 14 months we are only 7 or 8 months in – half way through?

Hence those lip smacking values you see right now may end up being the proverbial value trap i.e. what looks cheap now becomes cheaper still.

And of course, unlike my stock market game where every stock had a floor of 1c, bankruptcy is a very real outcome for many companies, driving their equity value to exactly NIL.

I have no panacea for the value trap except some guidelines when creating your shopping list in the value domain:

1. Follow the Graham and Dodd and Buffett concept of margin of safety between intrinsic value and a companies’ stock price.
2. Identify a catalyst that can cause a stock to revalue higher prior to investing e.g. a new product, new management, spin-offs, regulatory changes etc etc.
3. Purchase using Dollar and Time cost averaging.
4. Take responsibility for your decisions.

Where to Shop

 

That decision is yours alone but we certainly keep an eye out on those sectors that have been hit the most. Marketwatch has a nice industry screener for that. Here is a snapshot as of last week for the worst sectors by percentage change over the previous year:

Figure 2 – Marketwatch Industry Screener – worst performing over 1-year

Pour Conclure

 

January’s market lurch, the second since August 2015, likely indicates a bear market of greater magnitude ahead.

The time to get defensive was December ‘15 when calm reigned and there was a bullish undertone to the market.

Other times to become defensive will present themselves after spectacular short covering rallies. YOU WILL NOT FEEL LIKE SELLING when those happen!

The major benefit of playing defense, hedging or raising cash, and being correct is the ability to keep your KILLER INSTINCT intact so you can confidently put capital to work during panic squalls.

Now is the time to be compiling your buy list for the next and inevitable upswing – whenever that may occur.

Time to brush up on the stock market game!
Greg

 

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