Monday, November 22, 2004

Is Value Safe?

I don't believe this is the best time to begin trading. It is probably going to be one of the best times to learn to trade/invest, but it won't always be pretty.

You don't become a good trader from your gains, you become a good trader/investor from your losses. I knew many people who thought they were great traders during the end of the 90's. You can guess how that ended up.

The traders that didn't quit are better for it. They learned a valuable lesson. You are not as smart as you think you are. You need a strategy and not just CNBC. You need to be consistent. You can't just invest in a company because you heard its name from one of your friend's brother's cousins who knows this guy.

I say the above because I believe the stock market is in trouble. I would say that around March of '05, the markets are going lower...give or take a month. March 2005 is when, I figure, the higher interest rates will be hitting the bottom line of companies and that's when the negative earnings surprises will begin.

How do you pick stocks when in the back of your mind the market is going lower?

It's not easy; especially from such a small subset of stocks to choose from such as the Benjamin Graham Value candidates I'm looking at. Most of these stocks have been appreciating pretty well the past few months to a year. I should have become the SOO a little sooner. I'd be famous by now.

So, I need to choose stocks that will be able to weather the next investment storm. Stocks that have appreciated 50% or so are not going to be the concrete walls I'm looking for to protect me from the storm. I need something stronger than concrete...maybe a titanium type stock. When I find it, I will let my readers know.

Let's take a look at how value stocks have fared during some past downturns.

Most people believe that value stocks are less risky. Value stocks will go down less then the market during times of distress. That is not always the case. Naifu Cheng and Feng Zhang conducted a study called "Risk and Return of Value Stocks", which was published in The Journal of Business in October 1998.

One of their main conclusions is that the risks inherent in value stocks are going to most likely show up at the worst possible times. From 1929 to 1932, the S&P 500 fell 22.7%. Large-Cap value stocks fell 31.8% and small-cap value stocks fell 36.5%. Value stocks fell more than the market.

Another study, "The Value Premium," by Lu Zhang comes to a similar conclusion. He claims, " They (Value Stocks) are more risky than growth stocks in bad times and less risky in good times, but to a much lesser extent." Zhang claims this to be true because value stocks are typically companies with unproductive capital.

Unproductive capital suffers greater negative volatility in earnings because the burden of nonproductive capacity increases and they find it more difficult to adjust capacity than do growth companies.

That is what occured in the period from 1929 to 1932. The risk of value stocks does not show up in all recessions. 1973-74 was a period when value stocks were not as risky as the market. The S&P 500 fell 20.8% during that time period where large-cap value stocks fell 12.3% and small-cap value stocks fell 22.2%. Most believe that this was due to the fact of the high inflation during these times. Since most value companies are highly leveraged, inflation reduces the real cost of the debt.

The point is that during a recession, most stocks depreciate in value. Even value stocks will fall in a recession. Value stocks sometimes even fall more than the market. I am planning on there being a recession soon. I am not hoping there is one, but it seems rather likely.

This is not a good time to be investing, but it will be a great time to be learning. Maybe just watch me lose all of my capital. If you don't have much of a net worth, learn by watching.

I'll promise to find some of those titanium like stocks if you promise to learn something along the way.

Mr. Buffett must think I am all talk by now. He is the advocate for only wanting individuals to have 20 investments per life-time, though. I'll be coming Mr. Buffett, you just wait and see.

Best Regards,

The Soothsayer of Omaha


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