Wednesday, August 15, 2012

How Do You Know We aren't in a Bubble?

The title of this post is from something that happened to me in about 2005.  At that time, I was by myself driving when I noticed a funny bumper sticker that said: "Please God, just one more bubble". I looked at it and chuckled a bit and then went back to driving. Then a short time later a thought occurred to me which made me want shout out: "Wait, how do you know we aren't in a bubble?"

In hindsight we were indeed in a bubble in 2005: a housing bubble.

I mention this here because there is a moral to the story.  In investment we often are seeking a pattern to relate current situation to something that happened in the past, without thinking deeply to understand.  This is not good value investing thinking.  Value investing should be about being a owner in a business. And that requires understanding that business.

We didn't realize we were in a housing bubble because we had never seen one. Housing always went up.  By simply reverting to a pattern of housing always rising, we didn't try to contemplate falling housing prices. A lack of critical thinking caused complacency.

Now fast forward to today, the economic situation is very hard to grasp. It is the opposite situation, we are looking at a world that is clearly in uncharted territory.  We are looking for a pattern and we don't see one, so we are very susceptible to emotional arguments and sensational headlines.  So the market has priced in a very bleak future, the everyday retail investor is staying away from stocks.

But just because this is uncharted territory doesn't mean it is going to have a bad outcome. Yes, I am aware of the headlines.  Europe is in a mess with the euro. America has an enormous deficit and debt burden.  Banks are hobbled by regulation and their excesses of the financial crisis period.

But the world is rapidly changing and we always will have new problems. We are overlooking the positives, such as the growth of the middle class all over the world, a reasonable inflation rate and good corporate profits.

Good investing requires taking advantage of unprecedented situations. The good value stocks today won't fit the same criteria of the Graham and Dodd era. Each stock in each era requires its own criteria and sound judgment.

A case in point is my purchase of Philip Morris from 12 years ago.  I purchased MO just after the Engels verdict - the Engels verdict fined the US tobacco companies $150 billion in the summer of 2000, it was later overturned - Such a large verdict had no precedent in history.  However, US law forbids punitive damages that would bankrupt a company.  After the Engels decision, all the bad news was out, it is as bad as it gets, or the next step would be bankruptcy.  So at that moment, I bought in and the rest is history. MO has since been relatively successful at fighting off lawsuits and raising prices.  Now the original MO is split into three companies: Philip Morris USA (MO), Philip Morris International (PM) and Kraft (KFT). I estimate the gain to now has been 7-10x. (It is hard to add up all the dividends of all three companies).

As a final note to this story, the market has now changed its opinion 180 degrees! Tobacco companies are now the flavor of the month because they pay fat dividends and they have addicted customers.  These days tobacco is hardly cheap, MO and PM have P/E's above 15, more than MSFT or CSCO! Imagine that!

So nowadays I am slowly reducing my position in MO and PM, and trying to find my next big mis-priced stock to bet on.  This stock will probably be in an unprecedented situation, maybe it's hidden in plain sight.

Disclosure: I own PM, KFT, CSCO and MSFT. I have actually exited my MO

No comments:

Post a Comment