The Dangerous Temptation of Super-Cheap Stocks
Thursday, Oct. 23, 2008

Benjamin Graham was well prepared for the Crash of 1929. The now legendary investor had hedged his bets: he would buy preferred stock in a company and sell short common stock in the same company. When stocks crashed in October 1929, common shares fell much faster than preferreds, and Graham made a lot of money off short sales. 

But after the crash, most of those preferred shares seemed so cheap that Graham couldn't bear to part with them, he wrote in his memoirs. They kept falling, and his profit soon turned to a loss. His fund (equivalent to a modern hedge fund) ended the year down 20%. In 1930 it dropped 50.5%; in 1931 16%; in 1932 3%. "The stock market," as Graham resignedly put it in the first edition of his book with David Dodd, Security Analysis (1934), "is a voting machine rather than weighing machine." 

It had actually begun voting along with Graham by then — his fund gained 50% in 1933, and he did spectacularly well for himself in the next two decades. "In the short run, the market is a voting machine," he later took to saying, "but in the long run, it is a weighing machine." Over time, Graham's strategy of buying stocks that seemed inexpensive relative to a company's underlying assets and earnings really was (and presumably still is) a profitable strategy. But for months and even years on end, cheap stocks are perfectly capable of getting cheaper. 

It's an important lesson to remember these days. Stock prices have dropped a lot, so stocks look a whole lot cheaper than they were just a couple of months ago. By some — but certainly not all — measures they even look cheap in historical terms. But that's no guarantee prices won't keep dropping.
So while some value investors, most notably Graham's protégé Warren Buffett, have recently announced that they're in a buying mood, that's not necessarily a signal that the market has bottomed out. 

Buffett's most famous market pronouncement came in October 1974, when he told Forbes that, with the S&P 500 down in the low 60s after peaking at 120 the year before, he felt "like an oversexed guy in a whorehouse. This is the time to start investing." (The quote is from Roger Lowenstein's Buffett. In print, Forbes changed "whorehouse" to "harem.") That actually was pretty well timed — the market rebounded sharply in 1975. Then it dropped again, and the long secular bear market that had begun in 1965 didn't end until 1982. Buffett made tons of money in the second half of the 1970s — because he was a really smart investor and because he'd set up his investment vehicle, Berkshire Hathaway, as a self-funded enterprise that didn't rely on cash from (and thus didn't have to respond to the whims of) outside investors. But the S&P 500 was, when adjusted for the double-digit inflation of those days, actually lower in mid-1982 than when Buffett spoke out in October 1974. 

Add in dividends — the yield on the S&P 500 was 5.43% in 1974; it's just over 3% now — and stock-market investors came out modestly in the black over that stretch. They would have done much better, though, putting their money in gold or real estate or baseball cards. Then again, most of the gold bugs and baseball fans probably missed out on the market's great turn in 1982. Buffett and his fellow value investors did not.

We appear to be eight years into another of those long, secular bear markets like the one from 1965 to 1982, or 1929 to 1949. If you're looking for a bottom, an end to the pain, you're very likely to be disappointed. "Bear markets behave rather like Lucy in the Peanuts cartoon strip," Phil Coggan writes in this week's Economist. "Just when Charlie Brown is persuaded to attempt to kick the football, she snatches it away." 

The corporations whose shares trade on the stock market today are for the most part valuable entities, and the employees of many of them will find ways to make them even more valuable in the future — something that cannot be said of gold or real estate or baseball cards, which is why stocks can be expected to outperform all of those assets over time. It stands to reason that it's better to buy into stocks at today's prices than at those that prevailed a year ago. But it's also possible that they'll be even cheaper next year.