This article was originally published March 18, 2003.
My investment discipline prescribes purchasing stocks after significant price declines to low valuations in companies that maintain decent fundamental business prospects. Despite the rally of the past few days, many stocks still fit those parameters.
In the past week I've become more optimistic on the short-term prospects for the equity market. I don't think we've seen the secular bear market bottom, but it seems to me that we could experience a tradable rally through this spring.
As Warren Buffett contends in
2002 annual report, the stock market, despite its significant decline, is still uninteresting on a valuation basis. "That dismal fact is the testimony to the insanity of valuations reached during The Great Bubble," he wrote. In one sense, I completely concur. The popular cap-weighted indices such as the
still trade for valuations that should be considered fair-to-rich by historical standards.
The S&P's price-to-sales ratio of 125% and its normalized price-to-earnings ratio of 17 to 18 are hardly indicative of bear market valuation bottoms. No matter how much investors, Buffett included, maintain their disgust toward their brokerage statements, that sentiment isn't reflected in valuations on the indices.
Doing the Homework
But, in another sense, the market malaise has generated some reasonable values in second-tier companies. The median price-to-earnings ratio of the Value Line Index has corrected from last year's peak of 21 times earnings down to 14 times earnings as of last week. According to a column in
over the weekend, a full 20% of the S&P 500 trades for single-digit price-to-earnings ratios. Here's where I disagree with Buffett: I can find oodles of cheap stocks in big sectors of the equity market.
Don't get me wrong. They're not the highest quality names like Buffett's former "inevitables" such as
. And they're not the still-overpriced and overpopular large-cap tech stocks like
. But with a big chunk of the stock market, especially small- and mid-cap shares, as well as large-cap controversial stocks, below 10 P/E ratios, one can purchase reasonable businesses at attractive valuations.
In fact, that is precisely what Buffett is doing inside Berkshire Hathaway. In the past few years, Berkshire has spent billions of dollars acquiring a slew of decent companies for attractive prices. They include companies that manufacture insulation, carpets, apparel, textiles, housewares, food processing equipment, steel connectors, bricks, boots and paint. Buffett also initiated a significant position in the energy patch. Because of the continuing bear market, my guess is that investors today can purchase shares in decent (but mundane) companies cheaper than Buffett paid for controlling interests over the past few years.
Why does Buffett play down his acquisition efforts? Competition, of course. He doesn't want investors bidding up the prices of Berkshire's acquisition targets. And for the most part, investors agree with his verbiage. Many stocks in the manufacturing and energy sectors of the market remain cheap and uninspiring to professional investors.
I disagree with his contention about the dearth of attractive values in the stock market. When Buffett maintains that he finds "very few
stocks that even mildly interest us," I suggest you do as he does and not as he says. Purchase shares in a cheap industrial conglomerate, an undervalued apparel company, a bargain building-material business, or an inexpensive insurance firm. If the entire company were available, Berkshire would.
Many of the names that I recommended in the past have become better values during the winter correction. I still own and would buy large-cap controversial stocks such as
. In this vein, I've taken a starter position in a new idea,
The stock is down 65% from its peak to bargain valuations on persistent but modest earnings estimate reductions. The company faces some real challenges, including an oversupply of a major product and has poor free cash flow characteristics. But, should the company re-establish a reasonable growth rate from the current earnings levels, around $2 a share, the stock could be a big winner. If not, it would make an attractive acquisition target for
Johnson & Johnson
I've added to my Tyco holdings at current levels on the recent selloff. The company has eliminated much of its balance sheet risk and aggressive accounting policies. New management has lowered earnings expectations, as they usually do. If the company still has normalized earnings per share of $1.50, which I believe, the stock should trade back to the high teens or low $20s.
In the small-cap sector, I like some of my old favorites, including tech specs such as
. Buffett wouldn't buy these, but then he never buys tech shares. I'm comfortable buying cheap tech stocks.
Among mid-caps, I favor names like
Black & Decker
. If these businesses were for sale, I think Berkshire would be interested.
Do not take this column as a forecast for a new bull market. Like Buffett, I'm not bullish on the Nasdaq or the S&P 500. I'm sticking with my prediction of a down year and new lows, which we came very close to establishing recently. But, I've learned that oversold shares in average businesses at compelling valuations can make solid investments, even in a secular bear market. In purchasing partial positions in businesses such as these, investors would be simply following the actions of one of the world's best investors. There are far worse investment strategies.
Robert Marcin is the principal of Marcin Asset Management, a private investment firm. Formerly, Marcin was a partner at Miller, Anderson & Sherrerd and a managing director at Morgan Stanley, where he managed the MAS Value fund (currently Morgan Stanley Institutional Value). At the time of publication, Marcin was long Cendant, Cigna, Tyco, Tenet Health, EDS, Washington Mutual, Baxter International, Openwave, MRV Communications, Verisign, Abiomed, Artesyn, Health Net, Republic Services and Liz Claiborne, although positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Marcin appreciates your feedback and invites you to send it to