Investing the Templeton Way

April 7, 2024

John Templeton is one of the greatest value investors of all time as well as one of the greatest global investors of all time.  Thus, his methods are worth studying carefully.  The book, Investing the Templeton Way: The Market-Beating Strategies of Value Investing’s Legendary Bargain Hunter, is an excellent summary of Templeton’s methods.  It is written by John Templeton’s niece Lauren C. Templeton and her husband Scott Phillips, both of whom are professional investors.

In the Forward to the book, Templeton remarks:

We should be deeply grateful to have been born in this age of unbelievable prosperity…

Throughout history, people have focused too little on the opportunities that problems present in investing and in life in general.  The twenty-first century offers great hope and glorious promise, perhaps a new golden age of opportunity.

Templeton also notes that he is a value investor:

There are many investing methods available, but I have had the most success when purchasing stocks priced far too low in relation to their intrinsic worth.  Throughout my investment career, I have searched the world for the best bargain stocks available.

Templeton shares his motto:

To buy when others are despondently selling and to sell when others are avidly buying requires the greatest of fortitude and pays the greatest ultimate reward.

Finally, Templeton observes:

Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.  The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.

This is very similar to Warren Buffett’s advice:

I’ll tell you the secret to getting rich.  Close the doors.  Be greedy when others are fearful and fearful when others are greedy.

Here is an outline of this blog post:

• • The Birth of a Bargain Hunter
  • The First Trade in Maximum Pessimism
  • The Uncommon Common Sense of Global Investing
  • The First to Spot the Rising Sun
  • The Death of Equities or the Birth of a Bull Market?
  • No Trouble to Short the Bubble
  • Crisis Equals Opportunity
  • History Rhymes
  • When Bonds are Not Boring
  • The Sleeping Dragon Awakes

 

THE BIRTH OF A BARGAIN HUNTER

John Templeton learned early from his parents the virtues of thrift, industriousness, curiosity, and quiet self-assuredness.  The author Lauren Templeton says,

If I had to characterize his personality in one phrase, it would be ‘eternally optimistic.’

Authors Lauren Templeton and Scott Philips then write that John Templeton—whom they call “Uncle John”—was a value investor, which they define as follows:

We consider a value investor to be an individual who attempts to pay less than what he or she believes is the true value of a specific asset or object.  At the core of this definition is a simple but critical assumption: The price of an asset or object can differ from its true value or worth.

The authors mention that John Templeton probably got his first lesson in value investing from watching his father, Harvey Sr., a lawyer in Winchester, Tennessee.  Harvey Sr. tried many methods of making extra money, such as running a cotton gin, selling insurance, renting property, and buying farm land.  When it came to buying farmland, Harvey Sr. would only bid at auctions that failed to get any bids.  So he bought some cheap properties that ended up being worth much more decades later.

The authors note that a great irony of the stock market is that when prices drop significantly, there are few buyers even though it’s the best time to buy.

Another formative experience for Uncle John was when his father made a fortune in the cotton futures market.  He announced to John and John’s brother that neither they, their children, nor their grandchildren would have to work.  Only a few days later, Harvey Sr. came home and announced, “Boys, we’ve lost it all; we’re ruined.”  This likely caused John to learn not only about the importance of savings, but also about the ethereal nature of paper wealth and the importance of risk management.

The authors record that Uncle John and his wife, Judith, made saving money into a game.  For instance, they furnished their first apartment for $25 (less than $500 today).  One of Uncle John’s favorite purchases was paying $5 for a $200 sofa bed.  A few years later, after having their first child, they bought a house for $5,000 in cash, which they sold five years later for $17,000.  The compounded annual return on that investment was close to 28 percent.  Uncle John never used debt of any kind, including never having a mortgage.  The authors note:

Seeing the lengths to which Uncle John and Judith went to track down bargains is important because it is wholly analogous to the same intensive search process that Uncle John employed in searching for bargain stocks on a worldwide basis.  In a sense, when Uncle John was poring over Value Line stock reports, company filings, and other materials in search of a cheap stock, this practice was an extension of an innate desire to buy something selling for less than what he supposed was its true worth.  Whether it is furniture, a house, a meal, a stock, or a bond, it doesn’t matter: Look for a bargain.

The authors reveal that Uncle John often spoke of a bargain as something that sells for 20 cents on the dollar, an 80% discount.  It’s not easy to find this good of a bargain, but it’s a worthy goal.  Also, keep in mind that Templeton was saving up to launch his own investment counsel practice, which he later did with great success.

The authors continue:

Often in the world of business you will find that the most successful practitioners are driven to heights by a noble purpose.  Although some successful businesspeople are driven by money, many are successful because of altruistic intentions.  Although it often is misunderstood, Sam Walton’s vision at Wal-Mart was to lower the cost of goods for Americans.  He reasoned that this would put more discretionary money in their pockets and thus improve their lives.  Henry Ford wanted to bring an automobile to the masses rather than sell to the wealthy alone like all the other carmarkets at that time.  Rose Blumkin, the original proprietor of Nebraska Furniture Mart (probably the most successful furniture store to date, now owned by Berkshire Hathaway), always told people that her objective was to make nice furniture affordable to improve the lives of her customers.  This concept of “doing well by doing good” was popularized by Benjamin Franklin, and it has been a winning recipe for business ever since.

It is no wonder, then, that Uncle John’s early love affair with thrift and saving guided him to share his gift for compounding his investors’ money in the best bargain stocks he could discover.  Uncle John’s practice of thrift, his talent for bargain hunting, and his fascination with the compounding of interest was the exact formula necessary to make good on the advice of his mother, Vella: ‘Find a need and fill it.’  The need he identified was improving people’s lives by helping them create wealth, and his ability to fill that need was honed over the many years that led up to the launching of his own practice.  By the time Uncle John began his own practice, he had determined his contribution to his fellow men and women and was executing that strategy during every waking moment.

After completing Yale undergrad, Templeton went to Oxford on a Rhodes Scholarship.  During his breaks, he traveled widely.  He also read ahead of time about each place he visited.  The result was that Templeton gained knowledge about many different countries and cultures, which helped him later as an international investor.

Most U.S. investors only invested in U.S. stocks, largely because they believed the U.S. stock market was the only one that mattered.  Templeton, on the other hand, invested all over the world.  For Templeton, if a stock was a bargain, it was a bargain, regardless of where in the world it was.  Of course, finding such global bargains entailed avoiding specific countries where there was political turmoil such as Germany in the late 1930s.

The authors note:

The point is that even back in the first half of the twentieth century, when no one else bought foreign stocks, Uncle John was comfortable investing in other countries because he had taken the time to become knowledgeable rather than be guided by biases.

The authors add:

If there is one thread that stretches throughout Uncle John’s investing career, it is his ability to sit back and act with wisdom, not just smarts, although he has plenty of those too.  When Uncle John was a young child, friends and acquaintences of his mother always said the same thing about him, which was that he was ‘born old.’  The character trait that people saw in him as a young child was a unique blend of common sense and wisdom for someone with very little life experience.  Incidentally, that is what enables him to play a cool hand when it comes to the market.  It sounds so simple: Because he possesses innate wisdom and calmness, he is routinely able to see things that others cannot.  The fact is that it is simple but extremely uncommon.

Simple wisdom is often lacking for most investors:

Many investors say that they are anxious for a big sell-off in the stock market so that they can pick up bargains.  The facts state the case differently, though, when we see the Dow Jones fall 22.6 percent in a single day.  Where were all those enthusiastic buyers when the Dow carried a price/earnings (P/E) ratio of 6.8 in 1979 and stayed at those low levels for a few years?  What we find when we ask these questions is that buying stocks when no one else will is difficult for the majority of investors.  Incidentally, that is the best way to get a bargain, and getting a bargain leads to the best returns.

…

It is all a matter of perspective, and Uncle John’s perspective on the market is very unusual despite how simple it appears.  Consider this type of perspective in Uncle John’s own words: ‘People are always asking me where the outlook is good, but that’s the wrong question.  The right question is: Where is the outlook most miserable?’  The obvious application of this concept in practice is to avoid following the crowd.  The crowd in this case consists of the majority of buyers in the stock market who continuously flock to the stocks whose prospects look the best.  Avoiding situations in which the prospects look the best is counterintuitive to the way we conduct our normal day-to-day lives.

The authors continue with an observation about Templeton’s move from New York  to the Bahamas:

Uncle John always remarks that his results improved after he moved to Nassau because he was forced to think far differenly than the rest of Wall Street.

Warren Buffett, arguably the greatest investor of all time, lives in the quiet, small city of Omaha, Nebraska, rather than in New York.

Uncle John’s ability to take advantage of the market’s occasional folly or naive misconceptions was honed throughout his childhood and into this college years by sitting at, of all places, the poker table.  Uncle John in his earlier days was an expert poker player, or at the very least he was an expert compared to the boys in Winchester and, later, Yale and Oxford.

Templeton used poker winnings in order to pay for part of his education at Yale.  Templeton excelled at keeping track of cards and calculating probabilities, while simultaneously understanding the abilities and strategies of other players.  Roughly 25 percent of Templeton’s education funding can from poker winnings.  The remaining 75 percent came from working student jobs and winning academic scholarships.

The authors write:

Let’s say you are playing poker with the same group of friends as always and one player has a habit of bluffing under certain circumstances.  Since you have learned to spot this player’s bluffs, you usually can wait until he confidently raises the pot and then call when you are ready to take all of his money.  Well, you cannot exactly call someone’s hand in the stock market, but if a stock is trading at an exorbitant level in comparison to its measures of prospective earnings, cash flows, and the like, you can conclude that the market for that stock, like your friend, is a bit full of it.  In that case, you can be assured that your friend eventually will lose his shirt; and similarly, the market for that expensive stock will fall when investors figure out they are holding not a full house but a pair of threes.

 

THE FIRST TRADE IN MAXIMUM PESSIMISM

The authors write:

One of the key features of an asset bubble is that the market prices associated with the assets get much too high when the buyers are swept away by optimism and then later, after the market crashes, get much too low compared with the value of the assets as the sellers become pessimistic.  This exaggerated rise and fall typified the years preceding and following the crash of 1929.  Most important, this misbehavior of a stock price relative to the value of the company is not relegated to periods of market bubbles but can be a normal characteristic of daily, weekly, monthly, or yearly stock prices… The notion that a company and the stock price that supposedly represents its value in the market can become divorced from each other has its popular roots in the work and writings of Benjamin Graham, the coauthor of Security Analysis.  Graham postulated, correctly in our opinion, that every company has an intrinsic value; in other words, every company can be assigned a reasonable estimate of what it is worth.  However, in spite of this, the market for a company’s stock can fluctuate independently of the company’s value.

The authors later add:

This relationship is at the core of value investing: buying things for less than they are worth.  That is the idea.  As you will come to see later, you can arrive at this conclusion from a number of different directions.  Most important, this strategy should permeate all your investing, whether you are dealing in stocks, real estate, or even art, baseball cards, or stamps.  Identifying a discrepancy between what an asset is worth and its market price is the name of the game in every case.  Just remember that in each case the price of something and the value of that thing can be far different.  From here on, we will refer to this practice of buying things for less than they are worth as finding a bargain.

Many investors, even smart investors, can forget the difference between a stock price and the value of the company.  People can fall for a story about a company and forget the calculate intrinsic value based on the data.  The authors write:

Bargain hunters should never adopt a one-stop investment strategy that is based on well-told stories whether the stories come from your neighbor, your barber, or the smartest analyst on Wall Street.  Bargain hunters must rely on their own assessment of whether the stock price is far enough below what they believe a company is worth.  This is the sole guiding light on the horizon, and skepticism is the compass.  Buying stocks solely on the basis of stories about companies is like letting the mythological sirens entice you onto the rocks of the shoreline.  That rocky shoreline is scattered with the bodies of investors who listen to stories.

With respect to identnifying overvalued stocks, the authors write:

A tremendous body of research conducted over the last 50 years empirically confirms that stocks carrying a high ratio of price to sales, price to earnings, or price to book value make bad investments over the long run.

Furthermore, the authors assert:

…if you scanned your list of stocks ranked from the highest to lowest ratios of price to sales, price to earnings, price to book, and price to cash flow, you might discover that at the bottom of the list are some of the most unattractive, unexciting companies in the market.  Perversely, these companies have been proven over time to have the most rewarding stocks you can purchase.  If you chose to focus only on the bottom 10 percent of that list for an investment, you would be increasing the probability of your success as an investor a great deal.  Careful bargain hunters find that the bottom of this barrel is a fertile hunting ground for successful stock investments.

Later, the authors write:

When investors overreact to bad news and sell their stocks off feverishly, they are increasing the inventory of bargains for you to choose from; this is the perspective of a bargain hunter.  As a successful bargain hunter, it is to your advantage to have emotional sellers in the market beecause they create opportunities.  Similarly, it is to your advantage to have sellers in the market who are guided solely by the news headlines, the charts they look at, superstition, ‘hot tips,’ or anything else that diverts them from investing on the basis of the stock price relative to a company’s fair value.  The point is that these misguided participants are in the market and should be thought of as your friends.  They will create bargain opportunities for you as well as the best returns after you purchase shares.  In Uncle John’s words (tongue in cheek), these are the very people you want to help.  Your role as a bargain hunter is to accomodate them by offering to buy the stocks they are desperate to sell and sell them the stocks they are desperate to buy.

Uncle John has the benefit of seven decades of experience in the market.  His accumulation of experiences has made spotting bargains in the stock market second nature for him.  We noticed throughout our time investing under him that he kept getting better with each year he continued to invest.

Often what causes stock prices to drop are business problems.  One of the keys to successful value investing is learning to distinguish between problems that are either minor or solvable and problems that are either major or unsolvable.  The authors write:

Understanding the history of the market is a huge asset for investing.  This is the case not because events repeat themselves exactly but because patterns of events and the way the people who make up the market react can be typical and predictable.  History shows that people overreact to surprises [especially negative surprises] in the stock market.  They always have and always will.  Grasping that fact sets the table for bargain hunters to scoop up cheap stocks when a surprise occurs, and anticipating and looking forward to these surprises provides bargain hunters with the mindset to act decisively when the opportunity arrives.  Salivating for a big surprise that sends stocks into a frenzied sell-off is a common daydream for bargain hunters.

At the beginning of World War II, the U.S. stock market declined 49 percent.  Templeton thought this was a massive overreaction because he believed the United States would enter the war and would therefore need a huge amount of commodities and other products, which would be a massive stimulus for many American businesses.  On this basis, Templeton borrowed money—he already had plenty of cash but wanted to capitalize on this opportunity—and bought shares of every stock trading below $1.  Over the course of the next four years, Templeton’s investment quadrupled.

Note that of the 104 companies that Templeton purchased, 37 were already in bankruptcy.  Templeton calculated that the stocks of marginal companies would perform particularly well once the U.S. started producing commodities and other items for the war.  In the end, only 4 out of 104 investments Templeton made didn’t work.  Had Templeton only purchased the better companies, his results would have been far less good.  This is a lesson that a value investor should remain flexible.

The authors compared the results of some typical marginal companies Templeton invested in with the results of some typical better companies Templeton invested in.  As a group, the stocks of some typical marginal companies produced a 1,085% return whereas the stocks of some typical better companies only returned 11%.

Although Templeton’s investments had performed exceedingly well, he still recognized that he had actually sold a bit too early for some of his investments, some of which subsequently increased significantly.  Templeton reviewed his process for selling and made some modifications, which the authors discuss in the coming chapters.

 

THE UNCOMMON COMMON SENSE OF GLOBAL INVESTING

Although global investing is more accepted today, there were many decades—including when Templeton was doing most of his investing—when that was clearly not the case.  The authors write:

When Uncle John launched the Templeton Growth Fund in November 1954, he was on the cutting edge of global investing.  Often referred to as the “Dean of Global Investing” by Forbes magazine, Uncle John never had a problem looking past geographical borders to find a bargain stock to purchase.  There are two commonsense reasons for leaving the domestic market behind to find bargain stocks.  The first is to widen and deepen the pool of possible bargains.  If your goal as a bargain hunter is to purchase only the stocks that offer the largest differential between the stock market price and your calculation of what a business is worth, searching worldwide for these bargains makes sense.  For one thing, the bargain inventory from which to choose is exponentially larger.  For instance, your inventory for selection may jump from approximately 3,000 stocks in the United States to approximately 20,000 worldwide.  Therefore, your chances to succeed over the long-haul are much higher if you stay flexible and let the various stock markets around the world tell you where to invest.

In addition to obtaining a wider selection to choose from, it is common to find relatively better bargains in one country than in another.  If your mission is to exploit the opportunities created by pessimism, fear, or negativity, it is likely that one country will have a better outlook than another.  The differing outlooks and sentiment surrounding the various countries creates asymmetry in the pricing of the assets in one country versus another.  Put more simply, differing outlooks may make stocks a better bargain in one country than in another.

The authors also point out the by investing globally, you gain diversification.  No one can predict which global market will perform best and exactly when it will do so.  By spreading your investments across multiple countries, you can lower your risk without necessarily lowering your return.  Often it can take three to four years for a value investment to pay off, although sometimes it is sooner than that and sometimes later.   If, on the other hand, you were to wait for sentiment to change from negative to positive before investing, then you would be following the crowd and in many cases you would achieve lower investment returns than if you had invested ahead of the crowd.

To be clear: The crowd often achieves results that are average.  Net of fees, the crowd by definition will typically perform worse than a low-cost index fund.

Important Note: One thing that is not discussed in this book is investing in microcap stocks.  Very few professional investors ever even consider microcap stocks.  Therefore, if you focus there and you’re willing to do your homework thoroughly, it stands to reason that you could do well.  Warren Buffett famously commented in 1999 that if he were managing $1 million or $10 million, he would be fully invested.  Why would Buffett be fully invested during a bubble in U.S. stocks?  Because undervalued microcap stocks can sometimes perform well even as larger stocks experience a bubble and the inevitable bust.  In the same quote, Buffett guarantees that he could get 50% annual returns by investing in the most undervalued microcap stocks.

The authors comment:

What may be overlooked by some… is the strong performance of the Templeton Growth Fund during the 1970s.  By nearly all accounts, the 1970s was a difficult era to invest in as it was characterized by a number of treacherous factors.  There was the rise and fall of the famed story stocks known as the Nifty Fifty that grossly misled investors into heavy losses.  If that was not enough, investors also grappled with surging inflation, energy crises, and sluggish economic growth.  That decade provides a solid empirical argument for the benefits of bargain hunting combined with diversification.  In light of all the fluctuation in the economic environment and the lack of a discernably positive trend, the stock market of the 1970s was defined by the fact that the index ended at the same level at which it began the decade.  If you had invested in the Dow stocks at the beginning of the 1970s, chances are that you were invested for the entire 10 years with nothing to show for it.  Taking into account the rate of inflation, you would have lost wealth as purchasing power eroded heavily during that time.

The authors pose a question and then answer it:

Does the stock market have to go up for you to make money?  The simple answer is no.  If you are executing your strategy as a bargain hunter correctly—purchasing only the stocks that are lowest in relation to your estimation of their companies’ worth—you effectively are investing in only the best opportunities available.  In using this method, you are not necessarily tagging along with the performance of the market unless, coincidentally, the stocks that have the lowest price in relation to their worth happen to be in one of the popular market proxies, such as the Dow Jones Industrial Average, the S&P 500, or the NASDAQ.  This has happened before, for example, in the early 1980s, when Uncle John loaded up on the ‘famous name stocks’ in the United States as their P/E ratios had become thoroughly depressed to less than half their long-term averages.  More often than not, though, your collection of stocks will be unknown to most or avoided by most.  The broader idea at work here is to piece together on a stock-by-stock basis your most attractive collection of bargains available in the market.

One important related point is that, as a value investor, you never make a macroeconomic call about a particular country.  Templeton was known for seeming to pick the best countries to invest in.  But he always examined stocks on a case-by-case basis.  Templeton carefully picked the cheapest individual stocks he could find, wherever he could find them.  This strategy often led him to be highly exposed to one country or to a few countries.  But this resulted from bottom-up stock-picking, not from a top-down macroeconomic call.

The authors wisely point out:

The appropriate way to look at the ‘stock market’ is to view it as a collection of stocks rather than an index number.  When you view the market on a stock-by-stock basis, you will find that ay any particular time the stock market contains a number of individual bull markets and bear markets.  In fact, each stock is its own stock market; that is, each stock is composed of a number of buyers and sellers.  In applying this perspective, it is possible to locate a number of stocks that could perform well during a bear market for the indexes or poorly during a bull market for the indexes. (my emphasis)

While you may outperform during a bear market by investing in specific undervalued stocks, you are also likely to trail at times during a bull market.  The authors comment:

History shows that although your overall performance as an investor may be superior to the market averages, you can expect periods in which your performance falls short of the market.  Sometimes you may underperform by a wide margin.  Your edge as a bargain hunter is to have conviction that you did your homework up front and that time is on your side.  The market eventually will recognize what you already know  A few years of underperformance compared to the market should be expected.

If you accept this basic reality at the outset, you will have the psychological strength not to cut and run when the ball does not bounce your way in the short term.  The urge to switch out of your losing investments and into ‘better’ investments—usually meaning something that is rising in price—may be overwhelming.  It is important to resist these urges if your original analysis and research are sound.  No matter whose track record you are examining among the great mutual fund investors who have been at it for a decade or more, you will see that they went through periods of underperformance in spite of their long-term ability to outperform the market.

The authors explain that, during the 1970s, the Templeton Growth Fund produced 22 percent annual compound returns versus 4.6 percent for the Dow.  But the Templeton Growth Fund had lackluster results in 1970, 1971, and 1975 (minus 8.9 percent).  Had an investor abandoned the Templeton Growth Fund after a flat year or after a negative year, they would have missed out on some outstanding returns.  This also illustrates, again, that if you invest in undervalued stocks wherever in the world you can find them, you can produce excellent long-term returns even if there are bear markets in some or most of the global stock markets.

The authors quote advice from John Templeton:

‘The time to reflect on your investing methods is when you are most successful, not when you are making the most mistakes.’

Today, some investors complain about the lack of information when it comes to investing internationally.  The authors note:

To complicate the issue, the naysayers have this one right!  It is generally true that there is less information available on foreign companies, particularly if you are looking to invest in emerging markets.  However, your perspective on this reality can hep seal your fate as a global bargain hunter.  Do you see the glass half empty?  Are you scared off by the lack of information?  Or do you see the glass as half full?  Can you take advantage of this lack of information and seize it as an opportunity to make an investment ahead of the crowd?  Uncle John is the eternal optimist, and his practical response is to roll up his sleeves and do his homework.  Bargain hunters need to realize that finding stocks about which information is lacking is an effective way to find mispricings.

A good example of these information gaps and a working example of how Uncle John tackled them comes from his purchase of the Mexican telephone company Telefonos de Mexico in the mid-1980s.  At that time, the company’s reported numbers were unreliable in Uncle John’s opinion.  His solution was to count the number of telephones in that country and multiply that number by the rate the citizens were paying.  This required a great deal of work and research, but he then was able to determine that the stock price was far too low compared with what the company was worth, using his own projections.  This example may sound a bit extreme, but it is a good illustration of what a bargain hunter must be prepared to do in searching for the truth.

The authors say that the Mexican telephone company stock had gotten cheap because of the lack of information combined with the unwillingness of other investors to search for the information.  The authors write:

Often, the only hurdle is your unwillingness to work just a bit harder than the next guy or gal to get the answers.  Uncle John always considers this intense work ethic as a basic philosophy underlying success, whether in investing or in any other pursuit.  This belief in an exponential payoff to working harder than the next person is whta he refers to as the ‘doctrine of the extra ounce.’  This is akin to a famous piece of advice offered by Henry Ford: ‘Genius is 1 percent inspiration and 99 percent perspiration.’  Uncle John believes that in all walks of life, those who became moderately successful did almost as much work as those who were the most successful.  In other words, what separates the best from all the rest is a willingness to put in that one extra hour of reading, that one extra hour of conditioning, that one extra hour of training, that one extra hour of study.  Everyone has run across someone who was loaded with natural talent in his or her profession, sport, or classroom but never generated the amount of success that was there for the taking.  This reveals that sometimes being the brightest student or the most gifted athlete is a handicap.  This is true in every walk of life and every pursuit, not just investing.  The best bargain hunters realize that the one extra annual report they read, the one extra competing company they interview, or the one extra newspaper article they scan may be the tipping point for the best investment they ever make.

The authors note:

…we have found that the market is still teeming with stocks that have no research coverage or only a few analysts covering them.  These stocks should be considered prime hunting ground for bargain hunters who are willing to put in the work and do some original bottom-up analysis.  Stocks in the foreign markets with very little research coverage can carry major inefficiencies involving what is occurring in their businesses and how the market perceives those businesses.  Looking for and spotting these mismatches is a tried-and-true technique for successful global bargain hunting.

My Note: There are thousands of microcap stocks that have no research coverage at all.  A bargain hunter should not only look globally, but should also look at many of the smallest stocks globally.  I noted earlier Buffett’s assertion that he could get 50 percent per year returns by investing in microcap stocks, even as larger stocks were about to enter a bear market.

The authors next note that Templeton used a low P/E ratio as a way to identify potentially good investments.

This may strike some as very simplistic, but the truth is that the P/E ratio (price divided by earnings per share) is a good proxy or starting point for valuation.  Low P/Es led Uncle John into Japan in the 1960s, the United States in the 1980s, and South Korea in the late 1990s.

The idea is that you want to pay as little as possible for future earnings:

To tilt the probabilities of success in your favor, you should search for a stock priced exceptionally low relative to the earnings of a company that has better than average long-term growth prospects and better than average long-term earnings power…. To give you some idea of what his benchmarks of value were, Uncle John often looked for stocks that were trading at no more than five times the current share price divided by his estimate of earnings five years into the future… Likewise, he has remarked that occasionally he was able to pay only one to two times his estimate of earnings to be reported in the coming year.  That, of course, is dealing in an extreme situation of depressed value.  However, this is exactly what bargain hunters must be on the lookout for: extreme cases of mispricing.

Of course, it’s quite difficult to forecast the future earnings of a company, especially five years into the future.  But most analysts use historical figures to make such forecasts.  You have to assume average performance relative to a company’s history, which can include some great performance but also some lousy performance.  Of course, if there is a really compelling reason to expect stellar future performance, then if the price is right, you may have found an excellent investment.  The most important question is: what are the competitive advantages of the company?  As Warren Buffett has remarked,

‘The key to investing is determining the competitive advantage of any given company and, above all, the durability of the advantage.  The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.’

If the company has a durable competitive advantage, it becomes easier to forecast future earnings and therefore easier to determine if today’s stock price represent a bargain relative to those future earnings.

When it comes to curriences, Templeton assumed that currency trends tend to last for years.  Also, less risky currencies exist in countries with modest borrowing and high savings rates.  One potential problem in democracies is the voters tend to prefer more spending rather than less.  When politicians give the voters more spending, this eventually leads to inflation if the country has to keep increasing its overall government debt levels.  The higher the inflation, the faster the currency in question is losing value.

Templeton had a way of measuring the riskiness of investing in a given country:

First, if you want to avoid companies operating in riskier currencies, focus on companies with over 25 percent of their business performed in countries that export more goods than they import.  From another perspective this means that the exporter is accumulating reserves, or savings, and the purchase of its goods from other nations also can create upward pressure on the exporter’s currency (which thus should stabilize or even increase in value).  The second thing to determine is that the country does not have government debts that exceed 25 percent of its annual gross national product.  This measure gives bargain hunters a benchmark for what a conservatively managed government balance sheet should look like.  The problem that heavily indebted countries run into occurs when creditors or investors fear that they will not be repaid or will be repaid with a currency that has been devalued.  When creditors and investors become worried for these reasons, the flight from debt or investments they hold in the heavily indebted nation creates selling in that country’s currency, and the selling causes it to lose value.

Another basket of risks for bargain hunters to consider relates to the political landscape of a country they are considering for investment.  As we mentioned above, Uncle John is a huge proponent of free enterprise and the freedom of individuals to pursue their interests.

China is a good example, the authors note, of a government that believes in capitalism and freer markets.  Although the government in China is communist, the amazing wealth created in that country is because of its capitalist and free market realities.  Venezuela, on the other hand, is supposedly a democracy, but its leader has nationalized assets and transferred ownership from private to public hands.  Venezuela should be competely avoided by global bargain hunters.  After all, what is a business worth to global investors if the government can simply nationalize its assets?  The authors write:

The consequences of nationalized assets are often chronic underinvestment of outside capital and public capital, followed by the eventual underutilization and underperformance of the nationalized assets.  As a bargain hunter, you should avoid these situations at all costs.

The bottom line:

…nationalizing assets not only represents a poor investment but also goes against a deep philosophical belief that Uncle John holds.  That belief is that free enterprise and the competition that results from it lead to progress.  Progress is a very good and necessary thing for businesses.  Progress is also a very good and necessary thing in all walks of life, whether technology, science, or any other discipline.  When competition is stifled, progress is too.

My Note: As Ray Dalio points out in Principles for Dealing with the Changing World Order, the most fundamental force in human life is the force of evolution.  Evolution and innovation are what cause the economy to keep growing—through improvements in productivity—making most people better off on a per capita basis.

Both the United States and China, although using different political systems, are set up to maximize the improvements in productivity that result from the force of evolution being unleashed in free market competition.  To varying extents, many other countries around the world are set up to unleash the force of evolution through free market competition.

 

THE FIRST TO SPOT THE RISING SUN

The authors record:

There is no question that his heavy investment in Japan was led principally by the demonstrably low P/E ratios and high growth rates that the stocks and their companies carried in the 1950s and 1960s, but his intention to sit tight in the holdings and wait for their market values to rise no doubt was driven by viewing firsthand the same qualities that he held in such high esteem: thrift, focused determination, and hard work.  The people of Japan embodied those ideals, and the companies that employed them became economic manifestations of those characteristics.

Although Japan was viewed as a producer of inferior cheap products during the 1950s, the country was already transforming itself into an industrial power.  During the 1960s, Japan’s GDP grew at 10.5 percent per year, more than twice the GDP in the United States.

Templeton invested his personal savings into Japan in the 1950s.  But Japan had a policy of not allowing foreign investors to withdraw their investments.  As a result, Templeton waited before investing his clients’ money.  Templeton thought that eventually Japan would open its markets, and by the 1960s he was right.

The authors compare:

In the early 1960s, the Japanese economy was growing at an average rate of 10 percent and the U.S. economy was growing at an average rate of around 4 percent.  In other words, the Japanese economy was expanding 2.5 times faster than the U.S. economy, but many stocks in Japan cost 80 percent less than the average of stocks in the United States (4x P/E versus 19.5x P/E).  These are tremendous discrepancies, particularly when we consider investors’ long-standing love affair with high-growth companies.  How could such a discrepancy in the pricing of assets exist?  There are many cited reasons.  The reasons relate to the prevailing conventional wisdom at the time or simple misunderstandings.  The first reason is that investing overseas, particularly somewhere as exotic sa Japan in the 1960s, was basically too avant-garde for the time.

Moreover, the reasons given for not investing included the following:

‘Fluctuations in stock prices are too extreme.’

‘There is not enough information.’

The authors write:

Believe it or not, those are direct quotations.  As we can see, two of the main objections among active investors… were the exact things that Uncle John looked for in his search for bargains around the world.  Ironically, these two characteristics that kept investors away from Japan were the very things Uncle John found attractive in an investment environment.  Furthermore, these are just the reasons offered by professional investors.  There was another, broader layer of negative sentiment among the public in the developed markets.  That public sentiment was something along the lines of ‘Why would anyone invest in Japan?  After all, they lost the war.  They make trinkets in their low-wage factories and could never match the power and might of the United States in business.’  Those biases against the Japanese were inaccurate, unfair, and ignorant.  Most important to the bargain hunter, though, without their existence the prices of those stocks would not have been so low relative to the intrinsic worth of their companies.

The authors add:

Welcome to the world of neglected stocks.  This realm is one of your most cherished sanctuaries as a bargain hunter.  In many cases, when you are exploiting neglected stocks, you are not necessarily dealing with a large array of ‘problems’ at the company level or even the industry level.  Instead, you are tackling a heavy misconception or the mere obscurity of a stock in the broader market.  You might question how the market could overlook or ignore what was occurring in Japan at the time and chalk it up to the ‘unsophisticated’ nature of investors in the 1960s.  You might believe that these situations no longer occur in the modern market.

But this is not necessarily true.  These kinds of bargains continue to appear form time to time in various countries and regions around the world.  The authors say:

Sometimes the best opportunities are in plain view, but when investors see other investors passing them by or deriding them, they too pass.  Social proof is a powerful force, but work hard not to let it guide your investment decisions.  Often, what can happen—and what did happen in the case of Japan in the 1950s and 1960s—is that the entire economy can be transformed unnoticed by the crowd simply because they were unwilling to look in that direction.

Undervalued stocks may involve companies that are not expected to grow or they may involve companies that are expected to grow.  The authors write:

Uncle John’s main goal is to buy something for substantially less than its worth.  If that means purchasing somethingn with limited growth potential, that is okay; if it means buying something that should grow at a double-digit clip for the next 10 years, that is even better.  If the company is growing, the point is to avoid paying for the growth.  Growth in a company is a wonderful thing; your returns on a stock can go on for years if you spot good bargains in growing companies.  However, this is not an excuse to pay too much.  If you hypothesize that a company is about to knock the cover off the ball and be a long-term grower and then discover that the stock price has been bid up in anticipation of that growth, move on.  There is no reward for getting the fundamentals right if they already are built into the stock price.  As a bargain hunter, you should be focused on extreme mismatches between the way a stock is priced and what it is worth, not simple nuances.  These mismatches can occur in any type of company, at least from time to time.  Thus, as a successful bargain hunter you must remain agnostic about the superficial distinction between a value investor and a growth investor and resist creating biases that prevent you from spotting bargains.

Over time, Templeton thought carefully about when to sell a stock.  He came up with the notion that the time to sell a stock is “when you have found a much better stock to replace it.”  The authors note:

This practice of comparison is a productive exercise because it makes the decision to sell far easier than it is when you focus on the stock and the company in isolation.  When a stock price is approaching your assessment of what it is worth, that is a good time to be searching for a possible replacement…

To prevent the possibility of churning your stocks and creating wasteful activity, Uncle John recommends that you purchase a replacement only when you have found a stock that is 50 percent better.

Later, the authors write:

For Uncle John the decision to exit Japan was simple; he was finding better bargains in Canada, Australia, and the United States.  There was no qualitative factor that guided the decision; instead, the decision was predicated on the simple calculations of stock prices compared with the values of the companies.  Applying qualitative reasoning in this decision-making process would have muddled his judgment, and maintaining clear judgment is a central tenet in successful bargain hunting.

 

THE DEATH OF EQUITIES OR THE BIRTH OF A BULL MARKET?

In August 1979, Business Week had the following statement:

The death of equities looks like an almost permanent condition.

During the decade of the 1970s, U.S. stocks moved sideways and also experienced a couple of big drops.  As a result, many investors did feel that equities were “dead.”  The cover of Business Week said “The Death of Equities.”

Moreover, investors who had invested in commodities, real estate, or collectibles had done quite well during the 1970s.  The authors point out:

Of course, nearly 30 years later the magazine cover and the article penned on this theme are thought of mostly as a joke.  Many point to the cover as a fantastic buy signal for the stock market and an equally good time to exit commodities.  Bargain hunters in the stock market should have taken the magazine cover and the views that supported it as a point of maximum pessimism.  The market of 1979 and the three years that followed represented a state of nirvana for bargain hunters.

The authors then comment on the fact that finally pension funds gave up on stocks and were preparing to invest in real estate, futures, gold, and even diamonds.  The authors write:

When we think about this… it appears to be saying that the last holdouts in stocks are ready to sell.  So if we have reached a point where the last group of sellers is exiting the market, can prices fall much more after they finish selling?  No.  If the last batch of sellers leaves the market, you must have a keen eye to be the buyer on the other side.  Once all the sellers are gone, logically, there are only buyers left in the market.  Conversely, what about commodities?  They had been on a good run, and now the last group of buyers was coming into that market.  Once they were in, who else was left to buy commodities and bid them higher?  No one.  It should not be taken as a coincidence that the commodities market and the stock market were on the verge of trading places once the last group of sellers in one because the last group of buyers in the other.  This is an example of the mechanical logic that underlies contrarian investing.

The authors reiterate the fact that whenever there is a bubble, whether in stocks, commodities, or something else, you hear statements that it is a “new age” for investing in it.  You also tend to hear that “older investors don’t get it.”  Ironically, older investors were the ones who owned stocks from 1979 to 1982, the bottom of the stock market and the beginning of an 18-year secular bull market in stocks.  In investing, being older is an advantage because investing is a game where you get better with age and experience.

In brief, it was widely thought that it was “the death of equities” and a “new age” for commodities.  Exactly the opposite was true.  It was one of the best times in history to buy equities and one of the worst times in history to buy commodities.

A value investor could have recognized that equities were at one of their cheapest points in history simply by looking at P/E (price-to-earnings) ratio’s, which were near all-time lows.  Similarly, the P/E ratio’s for commodity-related stocks were near all-time highs.

As usual, Templeton coolly evaluated the situation from a value investor’s point of view.  He saw that U.S. equities had exceptionally low P/E ratio’s.

By the time 1980 rolled around, Uncle John had 60 percent of his funds invested in the United States.   That was in stark contrast to the stock market consensus at the time, which was that equities were dying on the vine thanks to runaway inflation.  Investors ran away from U.S. stocks as if they were a building on fire, but Uncle John took the opposite approach and calmly walked in the front door to size up the damage.  He did benefit from a fresh perspective on the market since he had not been riding U.S. stocks down into the pit of despair along with everyone else over the previous 10 years…

Why was Uncle John so bullish on American stocks when no one else would touch them with a 10-foot pole?  One part of the answer is simple: No one would touch them with a 10-foot pole.  The second part is that this prevailing attitude left some of the best-known, most-heralded companies in the United States, members of the Dow, trading at historical lows relative to earnings as well as book value, among other measures.

In fact, Uncle John researched the matter and could not find an instance in the history of the U.S. market in which stocks had been cheaper.  Keep in mind that this includes the Great Depression and the crash that began in 1929…. the 1979 average P/E ratio of 6.8 was in fact the lowest market on record.  In contrast… the long-term average P/E ratio for the Dow is 14.2x.

The authors then note that Templeton used many different measures, not just the P/E ratio, to determine when stocks were undervalued and thus a bargain.

Uncle John’s approach to bargain hunting always involved being able to apply one of the ‘100 yardsticks of value’ that were available to a securities analyst.  There were two good reasons for taking this approach.  The first and perhaps most important is that if you are limited to a single method of evaluating stocks, you periodically will go through times, even years, when your method does not work.  This concept is analogous to why you should never invest solely in just one country’s stock market for the lifetime of your investments.  If you stick with one region, country, market, or industry, there will be periods when you will underperform the market averages… Thus, if you rely on only a P/E ratio to evaluate stocks, there will be times when you cannot find value with that measure, but perhaps you could have with another, such as the ratio of price to cash flow.  For that matter, one cannot guarantee that your method for bargain hunting will not become obsolete.

…The second good reason to use many yardsticks of value is to accumulate confirmation of your findings from different methods.  If you can see that a stock is a bargain on five different measures, that should increase your conviction that the stock is a bargain.  Raising your conviction level is an important psychological asset as you face the volatility of the stock market.

Note: The Boole Microcap Fund uses five metrics for measuring cheapness:

• • EV/EBITDA – enterprise value to EBITDA
  • P/E – price to earnings ratio
  • P/B – price to book ratio
  • P/CF – price to cash flow ratio
  • P/S – price to sales ratio

The authors continue by noting that Templeton found that many U.S. companies in the late 1970s and early 1980s were trading at a low P/B (price-to-book value).  When a company has a low P/B ratio, that means the market has low expectations for the business in question.  Often these low expectations are justified if the business is performing poorly and will probably keep performing poorly.  However, sometimes a low P/B is based on temporary rather than permanent problems, in which case the stock may be a bargain.

Furthermore, Templeton realized that the replacement value of the assets for many businesses was actually much higher than the stated book value of the assets.  As a result, the companies with low P/E were actually trading at exceptionally low price/replacement value.  In fact, Templeton argued that on this basis stocks were at all-time historical lows.  The price/replacement value was about 0.59.  The authors comment:

The practice of looking deeper into the numbers goes back to our lesson about Uncle John’s doctrine of the extra ounce.  Only bargain hunters willing to put in extra work and extra thought would have uncovered the notion that stocks had never been cheaper in the U.S. market when viewed in terms of their replacement value.

In a similar vein, there is a parallel between this replacement value analysis and the analysis that Uncle John used to uncover the hidden value in the Japanese market that was discussed in Chapter 4.  In the instance of Japan, Uncle John made adjustments to the earnings of Japanese companies to account for the unreported earnings of the subsidiary companies held by a parent company.  In this case, Uncle John uncovered hidden value by adjusting the asset values of U.S. companies to their market values.  In both cases, Uncle John exploited an inefficiency in information that was not seen by casual observers.

Another clue that Templeton focused on indicating that stocks were significantly undervalued was that there was a large number of corporate takeovers.  Most businesses are well aware of what their competitors are doing.  When a competitor becomes undervalued, many businesses will try to acquire it.  So the fact that there were many corporate takeovers means many businesses thought some of their competitors were undervalued.  The authors note:

Uncle John became even more encouraged that the market was full of bargains when he saw that the prices competitors were willing to pay for those companies ranged from 50 percent to 100 percent above the market value of the target’s stock price.  This observation can translate into an everyday bargain-hunting strategy.  Many astute bargain hunters keep an active watch on the market values of companies whose value becomes too low relative to historical takeover levels in the industry.  The most common way bargain hunters detect these relationships is by examining the “enterprise value” of a stock relative to its earnings calculated before interesting, depreciation charges, and tax charges (commonly called EBITDA, an acronym for earnings before interest, taxes, depreciation, and amortization).  The enterprise value of a firm is simply the stock market equity value of the company plus the amount of debt the company has minus the amount of cash the company carries on the balance sheet.  The idea behind the ratio in this use is to get an idea of what a company would cost to purchase in its entirety, since you would have to purchase the equity from the shareholders and assume the company’s debt or pay it off.

The point in this calculation is to get a thumbnail sketch of what the takeover value of a company is relative to its “cashlike” earnings.  We say that EBITDA is “cashlike” because it often is used as a proxy for cash earnings, but it has some obvious blind spots.  In a working example, if we divide the enterprise value of our company by its EBITDA and find that the company’s enterprise value is 3 times its EBITDA and we have observed competitors in the industry buying other companies for 6 times their EBITDA, we may be able to conclude that the stock is a bargain on this basis.

Yet another thing that Templeton saw was that many companies were buying back their own stock.  When business leaders, many of whom understand their company and its value well, are buying back stock, that means they believe the stock is very undervalued.

The last clue that Templeton noticed was that there was an overwhelming amount of cash on the sidelines.

In 1982, Templeton appeared on the Louis Rukeyser show Wall Street Week.  He predicted that the Dow, then trading in the low 800s, would reach 3,000 over the coming ten years.  Viewers of the show and other market watchers thought Templeton had lost his mind.  But Templeton was using simple arithmetic.

Uncle John said that if corporate profits grew at their long-term average growth rate of about 7 percent and inflation remained at an expected run rate of around 6 to 7 percent, overall profits would increase approximately 14 percent a year.  If those 14 percent gains compounded annually, the values of the stocks would nearly double over the next five years, and if that held up, they would double again in the next five.  This corporate earnings activity alone would not require the stock market to assign a higher P/E multple in order to double.  However, with the Dow’s P/E ratio at around 7x compared with the long-term average of 14x, it was reasonable to see the index getting a lift from a return to the average P/E ratio as well.  Then, with all the money sitting on the sidelines and not being invested by institutional buyers, he believed that they was latent firepower to be deployed that would help drive the index higher.  In sum, with the environment as poor as it was and all the bad news priced into stocks, the probabilities of conditions improving were very much in his favor as well as the favor of all those holding U.S. stocks.  In the nine years that followed, his prediction proved correct.

Templeton had the courage not only to examine the situation of U.S. stocks with an open mind, but also to act once he realized how cheap U.S. stocks were.  One strange thing about people is that, even if they realize there are bargains among stocks, most people will not buy them until much later when the stocks are no longer great bargains.  In other words, most people feel comfortable following the crowd and so they miss chances to buy bargain stocks.

The authors conclude the chapter:

The way to overcome this human handicap is to rely on quantitative reasoning versus qualitative reasoning.  Uncle John always told us that he was quantitative in practice and “never likes a company, only stocks.”  If your investing methodology is based primarily on calculating the value of a company and looking for prices that are lowest in relation to that value, you would not miss the opportunity found in the death of equities market.  However, if you take your cue only from market observers, newspapers, or friends, you will be dissuaded from investing in stocks where the outlook is not favorable.  In contrast, if you are independent-minded and focus primarily on numbers versus public opinion, you can create a virtuous investment strategy that will endure in all market conditions.  Put another way, if you are finding stocks that are trading at their all-time lows relative to their estimate worth and you find that all other investors have quit the market for those stocks, you are exploiting the point of maximum pessimism, which is the best time to invest.

 

NO TROUBLE TO SHORT THE BUBBLE

Lauren C. Templeton describes visiting her Uncle John Templeton in early 1999.  Lauren asked him if he was buying technology stocks.

…[Templeton] described a number of financial market bubbles that spanned centuries, going back to tulips in Holland in the 1630s.  There was a Mississippi bubble conceived by French speculators, a South Sea bubble in England, and of course a railroad boom and bust.  Even in more modern times there have been speculative bubbles in wireless radio communication, cars, and televisions.  Uncle John has always been fascinated by this behavior, even to the point of having the Templeton Foundation Press issue a reprint of Extraordinary Popular Delusions and the Madness of Crowds.  What I found most remarkable about this recounting of economic activity that morphs into public euphoria were the common threads of economic circumstances and human behavior in each instance.  When you take the time to study the events, even the ones going back centuries, there are familiar elements in each one.  If you remember the Internet bubble, you probably have a rough sense of deja vu when you examine the South Sea bubble in spite of the fact that it occurred in eighteenth-century England.

The authors continue:

Take the automobile industry.  In its nascent stages during the early 1900s there were few barriers to entry in the business.  Just as the late 1990s and 2000 displayed a virtual explosion of dot-com companies, the early commercialization of the automobile in the United States in the period 1900-1908 brought a flurry of 500 automobile manufacturers into the industry.  The early automobile producers were really assemblers of parts rather than large-scale manufacturers, just as many early dot-coms simply had an idea and could build a Web site.  In either case it did not require much capital to start up a business.  Similarly, the public did not seem to contemplate the fate of the initially large number of players, and only the sheer force of competition eventually separated the winners from the losers.

This stands to reason, because the public usually grossly overestimates the industry at the outset.  In both industries whose booms and manias were separated by nearly 100 years, the large number of original players shrank dramatically after the busts.  Once competition forced the companies to survive on their own ability to make money rather than by raising money from investors, the party ended for the ones just along for the ride.  For every General Motors there are several New Era Motors Inc., and for every eBay there are several Webvans.  During the building mania phases when the public joins the fray, its willingness to support anything attached to the new industry is maximized.  In turn, investors often supply capital to even the most suspect newly hatched operators.  Those operators go belly-up when they are no longer supplied with capital, and the naive investors who backed them lose tremendous sums.

Another common thread in every stock mania is the outward display of optimism, with little regard for downside risk.  Typically, this optimism is buoyed by outrageous projections of growth for the industry.  Also, that growth is perceived to develop in a straight-line fashion without significant disruption.  When the automoble industry started a period of rapid growth during the 1910s, the unbridled optimism of endless growth was embraced as a simple fact.  Coinciding with this notion of endless growth was a latent assumption that there would not be a disruption in growth; instead, it would continue in a straight-line fashion.

The authors point out that in technology bubbles, it is often trumpeted that there is a “new age.”  This tends to be true in terms of the benefits of the new technology.  But that does not change the fact that there are so many new companies, most of which will never earn a profit and thus aren’t good investments for a bargain hunter.  The authors write:

Remember the first rule in bargain hunting for stocks: Distinguish between the stock price and the company the stock represents.  In this case speculators took the bright idea and bought it regardless of the stock price.  The stock price was irrelevant except that it was assumed it would continue to go higher becuase those companies were changing the world and nothing could stop their growth.  Speculators are always drawn into these investments because of the allure of the idea and the growth that is sure to follow.  As the automobile frenzy ensued in the years that followed, it became clear that the stock market had fallen under its spell of endless growth and profits.

The authors continue:

The auto stock traders bought cars with their winnings in the early 1900s, and the day traders of the 1990s took nice trips and bought electronics.  Different time, same story.  This behavior can lead to disastrous consequences when the speculators become more aggressive in spending their assumed wealth, which can be gone before the end of the trading day.  Similarly, when a large part of the public connects patterns with a forecast of increasing stock prices, it can have negative consequences for the economy when stock prices collapse and spending falls.

In the South Sea bubble in 1720, the South Sea Company,  a merchant shipping vessel company, struck a deal with the British parliament.  The South Sea Company would assume England’s debt, which the government would secure by giving South Sea a monopoly on trade in the Spanish Americas.  The authors report:

Seizing the opportunity, the South Sea operators quickly devised a plan to retire all of England’s debt in a similar fashion with the sale of equity.  Once the deal was approved and the stock was sold, visions of endless mines of gold and silver in South America and the riches that would accrue took hold of the public imagination.  Moreover, the directors of the company pushed those rumors to raise the stock price.  The draw of riches from the New World was too much to resist, and the English public became consumed with trading South Sea stock.  Observers who were befuddled by the day traders of the late 1990s would have been equally floored by the maverick day traders of South Sea stock in 1720.  Day traders have been an ongoing fixture in bubbles dating back at least to eighteenth-century England.  In every instance, their willingness to leave all their worldly duties behind in exchange for stock market riches has been unquenchable.

As the Pall Mall Gazette recorded in 1720:

“Landlords sold their ancestral estates; clergymen, philosophers, professors, dissenting ministers, men of fashion, poor widows, as well as the usual speculators on ‘Change, flung all their possessions into the new stock.”

The authors write:

The South Sea bubble, much like the Internet bubble, enticed all members of society.  The simple fact is that the attraction of easy wealth to a human is unbounded by time or geography.  No member of society is exempt.  Even the best minds of the time fall prey to it; Sir Isaac Newton lost substantially in the bubble.

There were people who warned against the South Sea bubble.  But there are always naysayers against bubbles, and the public tends to bowl right over the naysayers against bubbles.  In the dot-com bubble, day traders were glorified while old guard bargain hunters were criticized for missing the easy new wealth.  For instance, Julian Robertson and Warren Buffett, two of the greatest investors in history, were not long dot-com stocks and were criticized accordingly.  There was a Barron’s article titled, “What’s Wrong, Warren?”  The article said:

“To be blunt, Buffett, who turns 70 in 2000, is viewed by an increasing number of investors as too conservative, even passe.”

Moreover, during bubbles, there are always unscrupulous figures that emerge to take advantage of the situation.  Bernie Ebbers, the CEO of MCI WorldCom, was one such figure.  The company used its inflated share price as currency to buy out competitors.  However, eventually the company couldn’t find any more acquisitions, and so its reported earnings stopped going up and then later evaporated.  So Ebbers began fraudulent accounting in order to mask the declining conditions of the business.  Eventually the fraud came to light and Ebbers was imprisoned.  Investors ended up losing $180 billion.

The authors then mention Abraham White, who played a prominent role in the wireless telegraph bubble of 1904.  Guglielmo Marconi launched Marconi Wireless Telegraph Company, while a rival Lee De Forest formed the Wireless Telegraph Company of America.  De Forest, trying to catch the leader Marconi, needed to raise capital.  He met Abraham White.

White’s tactics as president can be be described as promotion on steroids with the intent of raising as much money as possible from the public.  There were publicity stunts such as fastening a wireless tower to a car and parking it on Wall Street, and they constructed a useless wireless tower in Atlanta to gain public attention.  Before long, White had raised the capital amount to $5 milion, or about $116 million in today’s dollars.  Shortly thereafter he merged the company with the International Wireless Company, [a] group of equally shady characters… Reportedly, the International Wireless Company, once the American Wireless Telephone and Telegraph Company, had been transformed under a string of acquisitions consisting of suspect stock-jobbing operators.  The combined company was thought to be worth $15 million ($350 million in 2006 dollars).

White pushed De Forest out and then focused on trying to inflate the stock price.  He issued phony financial reports to the press and sent promising prospectuses to investors.  He also used carnival-like publicity stunts.  Here is what White said in one speech:

“A few hundred dollars invested in De Forest stock now will make you independent for life.  Tremendous developments are under way.  Just as soon as the company is on a dividend basis the stock should advance to figures practically without limit.  If set aside for two years it is morally certain to be in demand at 1,000 percent or more present prices.  Those who buy will receive returns little less than marvelous.  A hundred dollars put into this stock now for your children will make them independently rich when they reach their majority.”

Money that came in from share sales were listed in the financial statements as revenue.  Thus the only way to boost revenue was to sell more shares.  White started exaggerating more than ever.  He promised President Roosevelt wireless messages to Manila in 18 months.  White promised a San Francisco-New York line.  He promised instant messages  from the Pacific coast to China.  The authors write:

By 1920, Abe White’s game was over.  The feds raided his offices in New York, citing the reams of literature that had been sent out extolling marvelous growth and an impregnable financial condition.  In sum, they were looking for mail fraud on the basis of the deluge of fantastical mailings and solicitations sent form the United Wireless offices.  What they found probably surprised them.  The feds discovered that the supposed assets of the company of $14 million did not exist; the value of the company’s assets was about $400,000.  The directors had controlled the stock through a lockup for the public holders by stamping the shares nontransferrable until 1911.  In the meantime, the directors kept adjusting the prices of the stock upward on the basis of new contracts (which were in fact money-losing) in $5 increments.  The stock began selling at $1.50 and was adjusted over time to $50.  In the meantime the directors unloaded their stock on the captive public, who could not sell it, at ever higher prices.  This scheme resulted in the fleecing of 28,000 shareholders who had been rabid for wireless company shares.  The feds relieved Abe White of his 15 million shares, which, priced at $50 before the raid, had run his personal stake to $750 million in 1910, or about $16.2 billion in today’s dollars.

The stories of Bernie Ebbers and Abe White unveil the ugly sides of stock manias.  Both show how crooks exploited greed among naive speculators and sold them a bag of lies.  However, even in the perfectly legal and morally acceptable circumstances surrounding stock manias, investors buy into a constant succession of newly issued stocks at exorbitant prices on the basis of what can only be called naive misconceptions.

In most stock manias, companies selling stock to the public for the first time through initial public offering (IPO) are even more frequent.  In the dot-com bubble, most companies that IPOed did so at vastly inflated prices, given that most of these companies ended up being worth zero.

John Templeton recognized the dot-com mania for what it was: a huge bubble.  Author Lauren C. Templeton writes:

I was at home with my parents for Christmas in 1999 when my father walked into the room and told me he had just received a fax from Uncle John.  The fax contained a relatively long list of NASDAQ technology stocks that Uncle John recommended selling short.

Again keep in mind that there were many technology stocks whose businesses were worth zero.  The P/E ratio of the NASDAQ in December 1999 was 151.7x.  Truly unbelievable!

However, leading up to 1999, there were many intelligent investors who tried to sell short the technology bubble.  These short sellers were crushed as stock prices kept rising.  The authors record:

Stocks went higher because the crowd willed them higher with more buying.  Stocks went higher simply because they had gone higher the day before.  Neophytes became stock market geniuses after one trade.  Day traders were running the show, and the main feature was momentum.  It was the only program, and if you did not like it, there was nothing else playing.  The concept of valuing a stock or the notion that a stock’s prices should be constrained by the company it represented was masked by the party tub of tech Kool-Aid, and too many people were drinking from it.

The authors talk about the perils of being early as a value investor.  When you’re long a stock that you believe is undervalued, but you’re early, you can have paper losses on your position.  But a stock that goes down becomes a smaller problem relative to the portfolio and is bearable.  The most you can lose is 100% if the stock goes to zero.

However, when you’re short a stock, you could potentially lose infinite amounts because there’s no limit on how high a stock can climb.  Therefore, it’s much more treacherous trying to short overvalued stocks, especially in a bubble when all stocks keep screaming higher.  There were many, many short sellers in 1997 to 1999 who lost tons of money and had to close their positions, locking in those losses.

So the question is: How do you short technology bubble stocks?  The authors write:

If only there was a way to figure outo what would spark the selling in those stocks and bring down the biggest charade in the history of twentieth-century markets.  There was.  Uncle John took a different perspective on this phenomenon to discover a hidden gem in the market and a highly probable approach to generating short sell profits rather than losses.  If there is one psychological element present in a stock market bubble, it is greed.  It is an old flaw among humans, and it is manifested routinely in the stock market.

The point is that there were buyers who were eager to cash out.  The young and old executives of the technology firms that were coming to the stock market in an IPO wanted to sell.

There are a couple of useful observations about IPOs in general that we can make as bargain hunters.  The first is that typically managers offer stock to the public when there is great enthusiasm for shares in an absolute sense.  It is widely accepted that no one can time the tops and bottoms of stock market runs, but it generally is accepted that a sudden surge in IPOs suggests that a market is inflating because managers and investment bankers try to maximize the amount of money they can raise for the company when they take it public.  Coincidentally, their efforts can run in parallel with more expensive market levels or, for that matter, with the later stages of a bull market.  The second observation is that when IPOs are made, the enthusiasm for the shares often pushes the offering price above its intrinsic value because of the heavier than normal demand.  It is not  unusual to see shares fall in price months after an IPO takes place as enthusiasm and demand die down and normalize when the stock is traded freely in the open market.

The authors continue:

In the IPO market of 1999 and 2000, the new-issue market was a quick way for business managers to cash out their inflated stakes at the public’s expense, and in many cases there were abuses.  Uncle John recognized that among all the participants in the technology stock bubble, those stockholders had the biggest incentive to sell.  Those company managers, or “insiders,” knew what kind of hand they were holding (a weak one) and were more than ready to cash out and take their winnings early.

That said, often there is a lockup period of 6 months during which insiders cannot sell after the IPO.  Templeton thought that when insiders were able to sell, they would do so, which would create the catalyst for the technology stock bubble to finally pop.  Day traders had the strategy of buying what was going up and selling what was going down.  If stocks were widely declining as insiders were selling, that would create a chain reaction in which day traders would also sell.  This would create a huge crash in technology shares.

Uncle John devised a strategy to sell short technology shares 11 days or so before the lockup expired in anticipation of heavy selling by insiders once they were allowed to unload their shares on the public.  He concentrated on technology issues whose values had increased three times over the initial offering price.  He reasoned that stocks that had increased that much in value provided an extra incentive to insiders to cash out and sell their holdings.  In sum, he found 84 stocks that met this criterion and decided to place a position of $2.2 million into each short sell.

All told, he bet $185 milliopn of his own money that tech stocks would plummet at the height of the bubble.  In the second week of March 2000, plummet they did…

Templeton taught to buy at the point of maximum pessimism, which is when there are no sellers left.  By the same logic, you want to sell (or short sell) at the point of maximum optimism, which is when there are no buyers left.

All of that said, it’s wise to use stop-losses if you decide to try to short bubble stocks.  In other words, determine ahead of time that you will close your short position if the stock goes up, say, 20% or more.  Templeton used an approach like this to control his losses from short selling.  Specifically, when a stock came out of its lockup period, if it increased strongly, Templeton closed his short position.

 

CRISIS EQUALS OPPORTUNITY

The authors write:

One way to think about the strategy of purchasing shares in the wake of a crisis is to relate the current crises to the same strategies that a bargain hunter employs on a daily basis in common market conditions.  First, the bargain hunter searches for stocks that have fallen in price and are priced too low relative to their intrinsic value.  Typically, the best opportunities to capture these bargains come during periods of highly volatile stock prices.  Second, the bargain hunter searches for situations in which a large misconception has driven stock prices down, such as the arrival of near-term difficulties for a business that are temporary in nature and should correct over time.  In other words, bargain hunters look for stocks that have become mispriced as a result of temporary changes in the near-term perspectives of selling.  Third, the bargain hunter always investigates stocks when the outlook is worst according to the  market, not best.

A crisis sends all these events into overdrive.  Put another way, when the market sells off in a panic or crisis, all the market phenomena a bargain hunter desires condense into a brief and compact period: maybe a day, a few weeks, a few months, perhaps even  longer.  Typically, though, the events and reactions to them do not last long.  Because of their ability to grip sellers, panics and crises create by far the best opportunities to pick up bargains, which drop into your lap if you have the ability to stay seated while everyone else dashes out the door.

To summarize, bargain hunters seek volatility in stock prices to find opportunities, and panicked selling creates the most volatility, usually at historically high levels.  Bargain hunters seek misconception, and panicked selling is the height of misconcepton because of the overwhelming presence of fear.  People’s fears become exaggerated in a crisis, and so do their reactions.  The typical reaction is to sell in a crisis, and the force of that selling also is exaggerated.  Bargain hunters look to take advantage of temporary problems that are exaggerated in the minds of sellers because of the sellers’ near-term focus.  History shows that crises always appear worse at the outset and that all panics are subdued in time.  When panics die down, stock prices rise.

When bargain hunters maintain the right perspective on crises and panics, they buy when everyone else is selling, which tends to produce excellent investment results.  The authors note:

If you have the psychological ability to add to your investments during future panics, you already have distinguished yourself as a superior investor.  If you can find the resolve to buy when the situation looks most bleak, you will have the upper hand in the stock market.

There is a strong historical precedent for buying in the wake of panic in the stock market, and those panics can come from a number of directions.  Panicked selling can arise form a political event (threat, assassination), an economic event (oil embargo, Asian financial crisis), or an act of war (Korean War, Gulf War, September 11 attacks).  Regardless of the underlying event, when markets make a concerted effort to sell on the basis of a negative surprise, bargain hunters should be looking to buy some of the shares others wish to sell.

Here is a list of recent crises including the number of days for the stock market to hit its low point, plus the percentage change of the drop:

Crisis	Event Date	Duration to Lows (days)	% Change to Low
Attack on Pearl Harbor	12/7/1941	12	-8.2%
Korean War	6/25/1950	13	-12.0%
President Eisenhower’s Heart Attack	9/26/1955	12	-10.0%
Blue Monday—1962 Panic	5/28/1962	21	-12.4%
Cuban Missile Crisis	10/14/1962	8	-4.8%
President Kennedy Assassination	11/22/1963	1	-2.9%
1987 Crash	10/19/1987	1	-22.6%
United Airlines LBO Failure	10/13/1989	1	-6.9%
Persian Gulf War	8/2/1990	50	-18.4%
Asian Financial Crisis	10/27//1997	1	-7.2%
September 11	9/11/2001	5	-14.3%

The maximum number of days for the stock market to reach its low point was 50, whereas the average number of days for the stock market to reach its low point was close to 11 days.  Four out of eleven crisis took only one day for the stock market to reach its bottom.

These events seem to happen a few times per decade.   The authors comment:

The truth is that most seasoned bargain hunters salivate for these events and remain in constant anticipation for them because of the opportunities they afford.  Whenever you observe people in the stock market who want to sell, you should feel the same urgency to buy.

The authors continue:

The basic premise here is that the best time to buy is when there is blood in the streets, even if some of it is your own.  Do not waste time watching your profits shrink or your losses add up.  Do not go on the defensive with the rest of the market; instead, go on an offensive mission to find the bargains coming to the table.  The goal in investing is to raise your long-term returns, not to scramble to sell.  Fixate on your goal.

You must also cope with negative news because negative news sells whereas positive news does not.

You can be sure that once the bad news becomes public, a thousand Chicken Littles will come out to proclaim that the sky is falling.  They will appear on the television, in the newspaper, and on the Internet and will draw a lot of attention.  Smart bargain hunters keep a skeptical but open mind when processing this information.  Is the sky falling?  History has shown repeatedly that it is not.

Sometimes a given crisis is compared to the 1929 crash, the Great Depression, or the 1987 crash.  These are worst case scenarios that are rarely (if ever) relevant to the crisis at hand.  Even 1987, while a large drop, was a one-day event and was far from being anything like the Great Depression, although comparisons inevitably were made.

The authors describe great leaders, who distiguish themselves when the chips are down.  They then write:

Similarly, the most successful investors are defined by their actions in a bear market, not a bull market.  Making money is relatively easy when the entire stock market is rising.  Aggressively seeking the opportunity provided through deep adversity when the stock market is in a free fall requires far more than the ability to analyze a company.  It requires a mindset that looks for a chance to shine, and this requires confidence and courage.  The only way to execute under this pressure is to have a deep-seated belief in your abilities and the conviction that you are correct in your actions.

Templeton had a list of stocks that he wanted to buy if the stock prices fell signficantly.  In order to help ensure that he would buy while the market was selling off, Templeton placed long-term buy orders for specific stocks at levels far below (such as 40-50% below) their current prices.

The authors caution that it’s important, when selecting which companies to buy during a selloff, that you select companies that have low debt or no debt.  Otherwise, the company you pick won’t necessarily survive a recession or economic downturn.  Low debt or no debt is also an important criterion that Warren Buffett uses.

The authors also point out that you should examine the net income of the company over time:

…you will want to measure the variability of its results over time as they are subject to different business conditions in the industry or the overall economy.  If the company was accustomed to losing money during any of its prior annual periods, this should be taken into consideration in purchasing its stock in case business conditions worsen.  Of course, this is a worthy consideration before investing in any stock regardless of future conditions.

 

HISTORY RHYMES

The Asian financial crisis started with the devaluation of Thailand’s currency (the Thai baht) in July 1997.  The authors record:

If the two currencies are misaligned too far, lenders to the government may realize that it cannot honor its ability to convert the currencies.  This realization can lead to a “run” on the currency as lenders and exponentially more investors speculating in the currency’s collapse rush to sell baht and convert to U.S. dollars.  If the government cannot honor those transfers, its typical response is to “devalue” the currency or release the stated pegged ratio that had been in place.  An example would be if you had 10 units of the local currency that equaled 1 U.S. dollar but the government did not have enough U.S. dollars on hand to accommodate the market and responded by saying that it now takes 20 units to buy 1 U.S. dollar.

The local currency buys far fewer U.S. dollars, or it takes a lot more local currency to buy a dollar.  Either way you look at it, it is a bad deal for people who want the government to honor its prior policy of converting local currency to U.S. dollars.  If the market senses that there is a high probability that the government will not be able to honor its obligation to convert the currency, a mad dash may ensue to pull money out before the government changes the peg.  The end result is a panicked selling of the government’s currency that drives its price down as well as the prices of assets denominated in that currency, such as stocks.

This dynamic became catastrophic for banks in a country such as Thailand, which secured its capital for lending by borrowing at the low interest rates for the U.S. dollar.  The bottom line is that if the local currency drops in value, loans taken out in U.S. dollars effectively increase in size.  If U.S. dollar loans increase too much, it can bankrupt the bank.

After the Thai baht lost significant value, investors then started worrying about other Asian countries whose currencies were pegged to the U.S. dollar.  As a result, there was heavy selling of these Asian currencies.  The authors note:

However, part of the problem in the case of Asia was that a group of countries referred to as the Asian miracles had posted strong growth rates in their economies over a number of years, and that attracted investors.   Over time the heavy investment led to too much money coming into the country, followed by overdevelopment in some sectors of the economy.  The overdevelopment would not generate the returns necessary to pay back lenders or investors.  In some ways, those countries were victims of their own success.  Nevertheless, the end result was a chain reaction of selling in those countries’ currencies as investors rushed to pull their money out as fast as possible.  The chain reaction leaped from Thailand to Malaysia, Indonesia, the Philippines, Singapore, and finally South Korea.  Eventually, similar fundamental dynamics led to deeply depressed currency values in Russia, Brazil, and Argentina in the years that followed.

Templeton singled out South Korea as a particularly interesting place in which to invest.  He had already identified the country as possibly “the next Japan.”  The authors say:

The reasons Uncle John may have considered South Korea to be the next Japan for investors could be seen in their striking similarities from an economic standpoint.  South Korea in effect was implementing the same game plan that had propelled Japan to economic success after its devastation in World War II.  South Korea had the same basic circumstances when it emerged from the Korean War.  It was a country that was left in an economic quagmire and forced to rebuild.  Although it took a bit longer to get on the right track, South Korea often is referred to as the best case of an economy rising from poverty to industrial power.

The authors compare South Korea with Japan:

First, both countries had heavy rates of domestic saving that funded investment in their economies.  Second, both were exporters but also, and perhaps more important, ambitious exporters.  In other words, Japan was dismissed as an unsophisticated producer of trinkets and cheap goods when it began rebuilding its economy after World War II.  South Korea had that reputation as it embarked on its economic journey to emerge as a powerful industrial nation.  It has been noted that well before South Korea developed its heavy industrial capabilities, it was known for exporting textile goods, and in its early stages of development its top exports were all basic “cheap” items.  For instance, in 1963 South Korea’s third biggest export was human hair wigs.  South Korea was directing itself down a path of progressive industrialization, and its economy was one of the fastest growing in the world as measured by growth in GDP.  The country’s economy had the highest average growth in the world over the 27-year period leading up to the Asian financial crisis.

Over the same period, the government’s direction of resources and capital into export-led businesses transformed the export mix from textiles and wigs to electronics and automobiles.  In addition to the overall higher growth rate, South Korea was able to resist signficant pauses in its growth as only the oil shock crisis of 1980 derailed a long period of uninterrupted high growth…

South Korea, like Japan, became less dependent on foreign borrowing and had ever-increasing domestic savings rates.  South Korea’s savings rate was above 30 percent until the 2000s.

When some of the noted chaebols, such as Kia Motors, Jinro, and Haitai, sought bankruptcy protection for failure to cover their interest payments in the summer of 1997, investors turned an increasingly critical eye toward South Korea and its financial situation.  The fear was that those bankruptcies and ones that could follow would feed back into the banking system.  Similarly, with large proportions of debt denominated in foreign currency, the appearance of risk was high.  From a perception standpoint, outside observers had no way to measure the potential severity of the problem, because disclosure was limited and the banks were controlled by the government.  Without being able to measure the problem, investors assumed the worst.

However, overall South Korea’s government borrowing was relatively modest at less than 20 percent of GDP before the crisis.  Nonetheless, South Korea had a real problem: A much larger percentage of its loans were in short-term maturities that had to be rolled over or extended on a regular basis.  That meant that the country’s debt had to be renewed in the middle of a regional financial meltdown.  The problem of defaulting borrowers in the Korean chaebol system was made worse by the simultaneous financial difficulties in Thailand and Malaysia.

One problem Korea shared with those countries was that they all seemed to have one major lender in common: Japan.  When the Japanese realized that they had so much exposure to the spreading defaults and bankruptcies in the region, they did not hesitate to pull the plug on South Korea.  The result was a near cessation of lending activity to South Korea despite the fact that its situation was not as dire as that of other countries.

Nonetheless, traders began heavily shorting the Korean won.  At first, the country wasted its reserves trying to support its currency.  This was futile, and after the country could no longer support its currency, the currency collapsed and that took down all asset markets with it, including the stock market.

The International Monetary Fund (IMF) arranged a $58.5 billion loan for South Korea, but it came with conditions.  South Korean had to open its financial markets to foreign investors and remove inefficient firms from the market.  South Korea agreed in early 1998.  South Koreans were not happy about inefficient firms being shut down because they were accustomed to holding a job indefinitely because of labor restrictions.  Furthermore, the government raised interest rates to prevent further deterioration in its currency.  This contributed to a recession, which further heightened the skepticism of investors with regard to South Korea.

Of course, Templeton, ever the contrarian, now decided to invest in South Korea because he thought the country was close to “maximum pessimism.”  Moreover, the P/E ratio’s in South Korea were low.  If an investor could look past the short-term difficulties including recession, the long-term outlook for South Korea remained very bright.

Most investors were of course avoiding South Korea.  Most investors, no matter how intelligent, do not have the willingness to buy near the point of maximum pessimism.

In the case of South Korea, although Templeton did invest in some individual stocks, he also invested in the Matthews Korea Fund, which had just declined 65%.  Investing in a mutual fund (or hedge fund) means you have to ensure that the mutual fund manager is a value investor, consistently buying stocks at low P/E ratio’s.  You also want a mutual fund or hedge fund that has good long-term performance.  If the short-term performance has been bad, that often represents a buying opportunity.

The Matthews Korea Fund ended up returning 278.5% from July, 1998, to July 1999.  It was the best-performing mutual fund in the world over that time period.

The authors comment:

Whereas most value investors in the United States were befuddled by the Internet frenzy, Uncle John was ringing up the best returns the market could offer.  This is the virtue of global bargain hunting.  Being a devout bargain hunter in only the United States would have kept you on the sidelines in 1999.  In contrast, being a global bargain hunter would have produced even better performance than was available gambling in the greatest stock mania of modern times.  Bargain hunting trumps the greater fool theorem once again.

In August 2004, Templeton invested $50 million into the Korean car manufacturer Kia Motors.  It has a P/E of 4.8x and was growing at almost 28 percent a year.  The stock then increased 174 percent.

The authors conclude the chapter:

Bargain hunters who understand history, focus on the long term and seek to buy at the point of maximum pessimism can appreciate the fact that these patterns repeat themselves over time, again and again.  Different place, different time; same story, same results.  While you may not be able to identify the exact repeating circumstances of emerging industrial powers in the future experiencing temporary problems you can be sure to find some that rhyme.

 

WHEN BONDS ARE NOT BORING

While Templeton shorted the U.S. stock market in early 2000, betting $185 million of his own money aqnd making a tidy profit, he was always very careful when dealing with other people’s money.  So his advice in March 2000, when asked, was to buy zero coupon bonds.  This was extraordinarily good advice.  When the economy slowed down, the Fed lowered interest rates several times, which significantly boosted the prices of zero coupon bonds.

Note: A zero coupon bond, instead of paying semiannual interest payments, incorporates the interest into the initial price of the bond so that the total capital gains over the life of the bond will include interest payments and the repayment of the principal.  The authors give the example of a 30-year zero coupon bond that pays 5 percent interest on a semiannual basis.  The price of this bond is about $227, which will become $1,000 by the time the bond matures.

Because Templeton thought the economy would slow and the Federal Reserve would therefore lower interest to boost the economy, the buyer of a 30-year zero coupon bond could make significant money over the course of just a few years.  Remember that the investor would initially pay $227 for a 3o-year zero coupon bond.  But if the Fed were to lower interest rates to stimulate the economy, the price of the 30-year zero coupon bond would jump up to reflect the new lower rates.

Before even considering these capital gains, though, it’s important to point out that, in early 2000, a U.S. investor could either (i) buy U.S. stocks and risk a 50 percent decline from very high P/E levels or (ii) buy U.S. government bonds yielding 6.3 percent.  That’s an easy decision.

But now back to the point about the Federal Reserve lowering interest rates.  The U.S. markets had gotten used to Alan Greenspan, the chair of the Federal Reserve, lowering interest rates when the economy was in danger of entering a recession or when stocks were crashing or when a financial crisis was possible, that the term the Greenspan put was invented.  The idea was that markets would always get bailed out by the Fed lowering rates at any sign of trouble.

A final step in Templeton’s recommendation was to buy 30-year zero coupon bonds from Canada, Australia, or New Zealand.  All of these countries had positive trade balances, small budget deficits (or surpluses in some cases), and low levels of government debt.

In March 2000, Canadian 30-year zero coupon bonds were yielding 5.3 percent.  As interest rates fell, those bonds would increase in price.  Rates actually declined to 4.9 percent, creating a 31.9 percent capital gain for the 30-year zero coupon bonds.  Translated back into U.S. dollars, the gain was 43.4 percent, or 12.8 percent anuualized.

Furthermore, Templeton recommended using borrowed money to purchase the Canadian 30-year zero coupon bonds.  An investor could borrow from the Japanese government at 0.1 percent.  Templeton recommended 2x leverage, which means instead of 43.4 percent the return would be 86.8 percent.

In other words, while U.S. stocks declined roughly 50 percent from early 2000 over the next few years, Templeton’s recommended investment strategy of borrowing from the Japanese government at 0.1 percent and buying 30-year Canadian zero coupon bonds generated a return of more than 86 percent over the same time period.  The three-year annualized return of Templeton’s recommended strategy was 25.5 percent.

The authors write:

The point of the discussion is that for a bargain hunter, it always pays to make relative comparisons.  Sometimes the comparisons must extend into securities such as bonds.  Although it represented an extreme situation in which Uncle John could not locate enough bargain stocks to place his money in, his process was sound enough to lead him into a profitable situation.  His process is and always has been defined by commonsense decision making and a willingness to do things others do not.  If we review his thought process on this trade, it came down to some simple questions: Should I risk losing substantial amounts of money in an inflated stock market or should I earn the 5 or 6 percent available in various long-term bond markets?  Anyone can see the logic behind this decision.  The reasoning is simple, not complicated.

The authors further point out that Templeton’s strategy was to hold the  bonds until there were cheap stocks, which would certainly be the case if the U.S. stock market declined 50 percent overall.

That said, Templeton was concerned about a housing bubble in the U.S.  He noticed that many homebuyers were paying four to five times more for a house than it would cost to contruct it.

Using his global lense, Templeton found a new market where there were bargains: China.

 

THE SLEEPING DRAGON AWAKENS

Templeton had identified China as the next great place to invest when he appeared in 1988 on Wall Street Week with Louis Rukeyser.  Then in a March 1990 interview for Fortune maganize, Templeton said the following:

“Hong Kong is rich in entrepreneurs who can start and run businesses, and there’s a great shortage in mainland China of people who know how to do that.  As a result, Hong Kong is likely to become the commercial and financial center for over a billion people, just as Manhatten is the commercial and financial center for a quarter of a billion people.”

The authors comment:

Today most readers and observers of financial markets take the significant economic presence of China in the world for granted.  However, when Uncle John described China as the next great economic power in the world in 1988, nearly 20 years earlier, that was very forward thinking.  Forward thinking is the calling card of successful bargain hunters.

The authors then compare Japan, Korea, and China.

All three countries had hit rock bottom, and Uncle John believed they were certain to emerge from that period of despair.  In the case of Japan, the country had been rendered economically prostrate by its disastrous fate in World War II.  It was left in such a state of ruin that investors believed it would remain an irrelevant economic backwater going forward.  In the same vein, when Japan began to rebuild, it attracted little serious attention from the major industrial nations, including the United States and Europe.  The industrial nations saw no impending threat from Japan, a producer of “cheap trinkets” in the 1950s.

South Korea was a nation left in economic devastation by the destruction caused by the Korean War.  Much like Japan before it, South Korea relied heavily on the financial aid of developed nations as it went through a rebuilding process during the 1960s.  When it took aim at becoming an industrial power, few believed there was any such capability in a country whose  third largest export at that time was human hair wigs.

In the case of China, no historical headline war event sent the country into an economic tailspin.  With a slightly closer look, though, we can see that political events within China during the middle to late twentieth century dismantled its economy and left the nation in shambles.  More specifically, we are referring to the regime of the communist leader Mao Tse-Tung and then the Cultural Revolution.  Both of those events left the country with the results that would have followed from losing a major war.

The authors continue:

The Great Leap Forward was an economic strategy developed and implemented by Mao in 1958 to move the country toward joint industrial and agrarian progress.  A central tenet of that strategy was that the state could manage the agricultural process, which then would generate the funds necessary for industrial ventures into steel production and eventually more advanced goods.  The first move by Mao to install the program involved the widespread collectivization of farmland into communes… This essentially meant that all property ownership was abolished, and reports suggest that 700 million Chinese were relocated into farming communes, with about 5,000 families per commune.  Once the families were relocated, they were forced to work in the fields to produce food for the country and fund the industrialization process.

Most bargain hunters will recall from earlier chapters that when the government nationalizes or expropriates private property, whether land or a  business, that stifles productivity and kills the spirit of progress.  Countries that implement those strategies make horrible investments as the effects are manifested in the economy.  In the case of China, the initial steps set the country on a fast track in the wrong direction.  Partly because of Mao’s willingness to lock up or expunge anyone who spoke against his policies and partly because of his stubbornness in not admitting a mistake sooner, the end result was massive starvation and loss of life.

To make matters worse, local government officials inflated the communes’ production statistics, perhaps out of hope for government praise or out of fear of the threat of retribution.

In the end, roughly 30 million Chinese starved to death and the same number of births were lost or postponed.

Mao conceded power to the prominent officials Liu Shaoqi and Deng Xiaopeng.  In 1966, Mao tried to regain his lost influence by instigating the Cultural Revolution.  Mao did this because the new leadership had become popular by reversing his reforms from the Great Leap Forward.

One consequence of Mao’s Cultural Revolution was the rise of the Red Guard, who began as a group of students defending Maoism.  Mao thought this was a way to spread socialism throughout China.

Part of that process was the eradication of “the four olds”: old customs, old culture, old habits, and old ideas.  The Red Guards had unlimited authority to enforce this dismissal of the four olds, and since they numbered in the millions, they exercised it ruthlessly.  The army and police were instructed to stand down and not interfere with the Red Guards’ actions or they would be considered to be defending the bourgeoisie and prosecuted.

The Red Guards took the opportunity to destroy churches, ancient buildings, antiques, books, and paintings and to torture and kill innocent people.  Some estimates put the casualties from the Cultural Revolution at 500,000 people or more…. The Cultural Revolution’s spirit of radical bullying persisted until the “gang of four” was arrested in 1976.  The gang was a group of powerful and high-ranking instigators (including Mao’s estranged wife) who were central to the drive of the Cultural Revolution under Mao.

The authors add:

As terrible as this event sounds from a humanitarian perspective, its consequences were equally severe and lasting on China’s economy.  During the Cultural Revolution nearly all economic activity shut down as the populace became concerned primarily with persecuting the old ways or running from persecution.  The government’s financial resources were redirected to support the Red Guard, and anyone who qualified as an “intellectual” was sent to a work camp for reeducation, including the two leaders Mao purged.  College entrance exams were canceled, and education stalled.  The lost 10 years in the educational system produced a gaping hole in China’s progress.

Only in 1977, after Deng Xiaopeng reemerged from a work camp to lead China again, did the country reinstitute its education system and implement serious reforms to undo the substantial damage caused by Mao over the previous two decades…

With Deng in control in 1977, China instituted a complete reversal and an open repudiation of the Cultural Revolution.  Deng’s intention to elevate the Chinese from their despair was made clear in 1979, when he said that “to get rich is glorious.”

Deng found a successful economic model near to China: Japan.

As you may recall from our earlier discussions of Japan and South Korea, there is a basic recipe that each of those Asian countries applied to rebuild its economy rapidly.  The Chinese were attracted to that recipe and began implementing it in their own way.  In each instance, a heavy savings rate is a major prerequisite for economic success.  A high savings rate is an attribute that Uncle John often favors in making foreign investments.  China proved adept at creating a large rate of saving across the country.  In fact, by the time Uncle John had mentioned China as the next great nation for investment in 1988, the country had achieved one of the highest savings rates in the world alongside Korea and Japan.

This heavy savings rate was the same strategy used by Japan and Korea to build financial reserves and finance industrial growth.  That growth would drive increasing exports with more value-added content over time.  China was determined to have the same success in exports that Japan and Korea had experienced in their rebuilding processes.  Like them, China began at the low end of the market by manufacturing textiles and “cheap stuff” for export.  That concentration on exports most often produced a trade surplus, which is another economic condition that Uncle John likes to find in a country.

… China was falling in love with capitalism and, of course, the spoils that follow business success.  The people needed little more than Deng’s prompt to strike while the iron was hot.

The authors later write:

Perhaps more important than the ambition of the Chinese was their ability to execute their strategy.  If we take a look at the country’s exports and their composition over time, we can see the familiar  progression from a onetime exporter of low-grade textiles mature to an exporter of industrial machinery and higher-value-added products.  If we compare the percentage of exports accounted for by textiles in 1992 with the percentage in 2005, we see a dramatic reversal.  That reversal was accompanied by tremendous growth and a higher percentage of exports in machinery, mechanical appliances, and electrical equipment.  In sum, textiles shrank to half their original percentage from 1992 and machinery increased to a percentage that was three times the 1992 level.  This reversal from low-value-added goods to more sophisticated exports of industrial goods mirrors the earlier advances in Japan and Korea.

China successfully transformed itself from a socialist system to a capitalism system.  China is now on track to overtaking the United States and becoming the largest economy in the world.

When the authors discussed China with Templeton, he said the following:

“The thing to always remember about China has to do with the people… You must not think of them as communists or capitalists… They are Chinese first, and that is how they see themselves.”

Templeton advised investing in China via investors who have their “feet on the ground” and who are up-to-date on local information.  Templeton also found two stocks in China in September 2004: China Life Insurance and China Mobile.

Templeton viewed China Life as a way to access the strength of the Chinese currency without paying a premium.  The stock traded as an ADR on the New York Stock Exchange.  The company would invest the premiums in the same currencies in which they did business, so as to minimize the risk of adverse currency developments.  Thus, buying China Life was a way for Templeton to access the local Chinese currency, which he found attractive over the long term.  Also, Templeton feared a decline in the U.S. dollar based on U.S. trade deficits combined with U.S. government debt levels.

Templeton’s China Life investment increased 1,050 percent over three years, a phenomenal investment.

Templeton’s other stock investment was China Mobile.  The company had a P/E of 11x, plus a growth rate of 20 percent.  So the PEG ratio (P/E divided by growth rate) was only 0.55, one of the cheapest stocks in the wireless telecommunications industry.  The worldwide wireless telecommunication 2004 group average PEG ratio was 0.84.

Templeton’s China Mobile investment ended up returning 656% over three years, another outstanding investment.

Templeton began advising that instead of forecasting a company’s earnings five years into the future, you should now try to forecast a company’s earnings ten years into the future.  The authors write:

…by focusing on the future prospects of a company as much as 10 years into the future, a bargain hunter has to think about the competitive positioning of a company in the market.  In short, bargain hunters must devote a large majority of their efforts to determining the competitive advantage of a business in relation to its competitors.  This requires putting a great deal of effort into studying not only the company whose stock you are considering for purchase but also that company’s competitors in the market.

Uncle John always said that when he visited a company in his early days as an analyst, he always got the best information from the company’s competitors, not from the company itself.  The aim of this analysis is to get a sense of how well a company will be able to maintain its profitability into the future.  This is a key consideration if you are going to make an estimation of a company’s earnings 10 years ahead.

The authors point out that a basic rule of economics is that excess profits attract competition, which tends to reduce those profits.  How defensible are the company’s profit margins in the face of increasing competition?  If a company has a sustainable competitive advantage—which is also something Warren Buffett and Charlie Munger look for—then that is an encouraging sign.  Whether its a low-cost advantage, a brand image advantage, a market share advantage, pricing power, or some other advantage, it pays to figure out if the company does have a competitive advantage and whether it is sustainable far into the future.

A key question is: How easy would it be for someone to replicate the business in question?  The more difficult it would be to replicate a given business, the more valuable that company’s earnings are to an investor.

The authors conclude:

Always looking for investments differently than others do (whether in a different country, with a different method, with a different time horizon, with a different level of optimism, or with a different level of pessimism) is the only way to separate yourself from the crowd.  By now you should know that the only way to achieve superior investment results is to buy what others are despondently selling and sell what others are avidly buying in the market.

The authors quote Templeton:

“If you want to have a better performance than the crowd, you must do things differently from the crowd.”

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods.  We also aim to outpace the Russell Microcap Index by at least 2% per year (net).  The Boole Fund has low fees.

 

If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail: jb@boolefund.com

 

 

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.