The Business of Value Investing.pdf

60 The Business of Value Investing

Making matters worse, the fi rst proposed temporary assistance

relief program, in which the U.S Treasury proposed a $700 billion line of

credit to buy the troubled assets of the fi nancial sector, failed to pass a

vote by the U.S. House of Representatives (the vote later passed), which

sent the Dow Jones down nearly 800 points, or 7 percent, on September

29, 2008. This represents the biggest point drop in Dow history and the

second largest percentage fall after the October 1987 crash.

Stock prices in general have been declining for well over a year,

but on September 29, 2008, stock prices went into a free fall. That

day, $1.2 trillion in market value was wiped out (the fi rst time over $1

trillion was lost in a single day). Aside from fi nancial institutions—some

of which declined by over 50 percent that day—perfectly sound (and

often debt-free) businesses suffered single-day losses that in some

instances exceeded 20 percent. In such times, markets can experi-

ence prolonged periods where valuations simply do not matter. In

late 2007, plenty of strong nonfi nancial businesses were selling for

under 10 times earnings, with little or no debt, and producing gobs of

free cash fl ow. Today some of these same businesses are now trading

at two to three times forward earnings.

Yet these valuation metrics don’t seem to matter when markets

are in a state of turmoil. In the short run, the market moves on the votes

of participants, not the quality of businesses. It’s crucial for investors to

understand the difference between a stock price decline as a result

of an overall bear market versus a decline in the intrinsic value of a

business. Global economic slowdowns will certainly reduce intrinsic

values if future earnings are set to decline. But just as stock prices tend

to overshoot during periods of endless optimism, they can also under-

shoot during periods of endless pessimism. And these periods can last

several months or many years. Timing markets is a fool’s errand while

pricing stocks is an investor’s goal. Nonetheless, even value investors

must learn to respect the market and realize that bear markets can

put you to the ultimate test of patience.

Determining whether the stock price indicates an undervalued

or overvalued business is challenging. Consider a bond, which is

relatively straightforward to value. If the bond currently pays $ 500

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