by Henry Lee | April 24, 2014 2:31 pm
If the recent volatility in the market has you feeling uneasy, you’re not alone. That feeling in your gut means something. Listen to it.
After hitting a fresh high of nearly 1900 on April 4, the S&P 500 (INX) closed last Friday at 1816 – a 4.3% drop in just one week. We’ve seen a bit of a rebound, but the worst week in two years rattled investors. Nasdaq (IXIC) got close to a 10% drop from its March high, which would make it an official “correction” – a nice word that masks the pain many investors are feeling.
There isn’t one specific headline to drive the selling, so we’ve heard a lot about the “momentum meltdown,” as the likes of Tesla (TSLA), Twitter (TWTR), Facebook (FB) and other high fliers have caught more than a few investors off guard with how much they sold off.
And that’s the problem. Momentum is fine… until it stops working. It’s human nature to want to own stocks that keep going up, but that’s also when they become the most vulnerable.
When the momentum ends – as it inevitably will – it can be devastating. Remember, climbing back out of a hole is a lot tougher than falling down in. You need a 33% bounce to recover from a 25% loss, and a double to recover from a 50% loss.
The reality is that we cannot avoid volatility if we invest in the stock market, which we absolutely need to do to truly build wealth. The key is to invest in companies that still allow you to sleep at night and take advantage of the fear so many other investors are felling to buy stocks selling at a significant discount to their real value.
As contemporary value stock investors, my readers and I buy stocks already selling at a discount, not the overvalued high-fliers that have been hit hard, so we already have less downside risk. On the flipside, selling creates wonderful buying opportunities as panic takes take over and many investors practically give away their stocks.
Warren Buffett put it well in his most recent letter to shareholders:
“Owners of stocks…too often let the capricious and often irrational behavior of their fellow owners cause them to behave irrationally as well.” He goes on to say that “tumbling markets can be helpful to the true investor if he has cash available when prices get far out of line with values. A climate of fear is your friend when investing; a euphoric world is your enemy.”
Value stock investors are in a unique position to make a climate of fear our friend. We focus on companies already trading below intrinsic value, and that discount provides a built-in margin of safety with less downside risk. At the same time, we look for catalysts to drive future value and close most or all of the current discount. The result is an “asymmetric” investment in which we risk $1 to make $2, $3, or $4.
An excellent example is Genworth Financial (GNW), a stock I have owned since it was trading around $6 share, so it is approaching a triple for me. That said, I recently recommended it to my Contemporary Value Investor readers because it is still an excellent buy. GNW remains undervalued, and the recent selling has brought it back under my recommended buy limit.
There was plenty of fear around when I first bought Genworth. It was suffering from financial distress having written insurance on residential mortgages prior to the financial crisis of 2008.
Management had done some smart things, such as isolate the mortgage insurance unit from the rest of the business in the capital structure. This way, if the mortgage business ever blows up again, the losses will be isolated and less likely to take the entire business down.
In addition, management has levers to pull for further value creation, especially the IPO of its Australian mortgage unit, and I expect the large discount to book value to eventually be eliminated. The recent pullback is a buying opportunity. I’m targeting nearly 25% gains from current prices with not a lot of downside risk.
I bought the stock because of its large discount to book value and the fact that new management was making clear progress turning the business around. Those remain the reasons to buy it. GNW trades at a sizable 55% discount to its fourth-quarter 2013 book value, and is trading around 11.6X expected 2014 earnings and 9.8X 2015 expectations.
As we said, we can’t avoid volatility, but as value stock investors, it’s nice to know that we’re positioned to not just withstand it but use it to our advantage.
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