Part of being a value investor involves being a contrarian. Most of the time, you will be standing against the current of market opinion, buying when others are selling in a panic and selling when others are buying stocks with great abandon. You will be buying stocks in industries that are out of favor with the mainstream investing public and that have ugly short-term outlooks. You will be focused on things no one cares about in these short-term oriented markets, like cash flows, asset value and balance sheet strength. Quarterly earnings seasons will be a stepping stone in a long journey, not the stock market equivalent of a quarterly Super Bowl of trading.
You will be spending the majority of your time standing against the idea that has the world in its grip as far as equity markets are concerned. You will not be a believer in new paradigms or regimes. You will not be a bull or a bear on the market, but a seeker of safe and cheap stocks that tries to be agnostic about market movements. Whatever the popular sentiment is, your first question will always be: "what is wrong with this picture?"
Right now there are two central opposing themes that dominate most market participants. The first is the bull case. Interest rates are low and will stay low for a long time. This means stocks are the best game in town and money will be forced to flow into equities. Low rates also make it possible for companies to borrow low-cost money and buy back enormous amounts of stock, providing yet another source of demand. From a longer term perspective, the economic recovery will eventually strengthen and conditions will be strong enough to overpower the eventual rise in rates, and stocks will just keep going higher.
The other side of the argument is that there is no way this grand experiment of the Fed ends well. Rates will go higher and stocks will collapse. Things like the market cap to GDP ratio, the Schiller PE Ratio and Tobin's Q ratio are all very high, and stock prices will have to fall to bring them back into line with economic reality. We have not had a correction for more than five years and the stock market is overdue for a collapse.
Both are powerful arguments. More hold the bull side right now, according to sentiment indicators, but there are still plenty of voices in the bear chorus. The question of the day from my perspective is: "what if they are both wrong?" What if stocks just meander sideways for an extend period of time and allow earnings, assets and cash flows to catch up to current stock prices? What if rates go up in a fairly measured fashion, providing only lukewarm competition for stock prices, and we have a sideways market that offers little to no returns for several years? That is the scenario no one is expecting.
If that happens, how will you make money in stocks over the next few years? The first and most obvious thing to me is something I have talked about almost incessantly over the past few years. No matter what the stock market does over the next several years, community bank stocks should do very well. The economic, demographic and regulatory forces driving consolidation in the sector will exist no matter what happens in the overall stock market. Those banks that remain independent will be those that dominate their local markets and produce the type of earnings and dividends growth that take the stock higher in either a bull or a bear market.
Outside of the little banks, your best chance of making money will be buying stocks that are cheap based on asset value, and pay dividends. If your can buy companies for less than asset value, you open yourself up to what Marty Whitman calls resource conversion opportunities. In a sideways environment, positive corporate events that unlock asset value will be a primary driver of individual stock returns. Dividends will become a much larger component of stock returns as well, and the focus could shift from buybacks to cash payouts to shareholders.
Focusing on value and dividends can prepare you for whatever happens in the market in the years ahead. Stocks like International Shipholding (ISH), Ampco-Pittsburgh (AP) and Transocean (RIG) are throwing off cash and should hold up better that the market in a correction, due to their valuable asset collections that can be bought at a discount right now. The high yields of REITS like Campus Crest Communities (CCG) and Preferred Apartment Communities (APTS) will provide cash returns regardless of what the market does in the future, and there is always the possibility of a transaction that unlocks the value of the assets no matter which scenario plays out.
Small banks value and dividends are the contrarian way to succeed, regardless of what prediction comes true.
