It has been a tough couple of months to be a deep value investor. As the markets began to plummet in August, I was buying some stocks that become incredibly cheap. I bought and suggested European banks and insurance companies as well as some U.S. regional banks. As happens so often, they rallied a bit and first and then resumed their downward movement. It is a very familiar position for me. I do not think I have ever bought a stock that did not continue to go down before reversing course. It is the biggest reason I tend to scale into positions. When I am buying into a falling market, I usually will start by buying 20% to 25% of what I would consider a full position in a stock. If volatility is high, as it usually is in a falling market, I will consider selling puts or a combination to establish an additional 20% to 25% of a full position. Not only does this commit me to buying more stock at lower prices, it helps finance the purchase.
It is clearly a difficult time for any type of investor. I have been around for a long time in this business, and I do not recall ever dealing with as many global macro issues as we are right now. The Europe situation is just a mess and the message out of Germany is somewhat mixed. I have said from the start of this that a true fix to the debt crisis was dependent entirely on the will of Germany to fix it. The Germans have to write the checks because no other eurozone nation that has the ability. The news that the Chinese are willing to step in and buy the paper of distressed sovereigns is perhaps a short-term boost, but I am not real pleased with the long-term implications of such a move. I have no clue how long the European problems will continue or what the eventual fix will be, and I do not really think anyone else does either.
It is no better here at home. The political situation is just short of insane with a lot more finger pointing than problem solving coming out of Washington. Unemployment is still a major problem and real estate has failed to stabilize. In 2008, I said that these were the two keys to a recovery, and I see no reason to change my opinion now. This week, we saw the first decreasing in an analyst's estimate for the S&P 500 and we will see more. Finance, energy and consumer discretionary companies make up more than 35% of the index and all three sectors could be subject to drastic earnings estimate reductions in the last few months of the year. Estimates of GDP growth are also declining and that doesn't really bode well for corporate earnings.
I will reiterate that I have no clue what is going to happen in this market. There are too many variables. Even in face of such uncertainty, we have to have some sort of game plan, so here is how I am going to approach buying stocks for now. I have my initial position established and I have my watch list of stocks that I want to buy at lower levels. My first trigger to add to positions is going to be percentage of book value. If I bought a stock at 80% of tangible book value and it falls to 70%, I will add to my position. If a stock on my watch list falls below tangible book to the 90% level, I will establish an initial position or sell puts to back into the stock.
My second indicator to add or buy is one of the two technical indicators I have relied on over the years. It should be no secret that I am not a big technical guy, but the NYSE Hi-Low ratio established by the folks at Investors Intelligence has proven itself over the years a highly reliable overbought oversold indicator. I have tested it by hand and with a computer and it works very well for catching points of maximum pessimism and optimism in the stock market. If that indicator falls below 10 as it did in August, I will add to positions as well.
It is a very uncertain time but if we rely on valuations and look for the point of maximum pessimism, we should be able to scale into positions that offer substantial long-term rewards.