Bubbles and Busts: How Value Investors can Profit

This guest post on Bubbles and Busts was written by Henry Jackson. Henry is a private investor based out of New York. Article image (creative commons) by Geralt.

How do value investors sidestep bubbles built on irrational exuberance and exploit the busts that follow? Since Bitcoin’s rise I have been asked, do I still study annual reports while others are making quick money speculating in Bitcoin?

My answer, yes!

That being said, have I been tempted to put aside another net current asset valuation (NCAV) estimate and put money into Bitcoin or some other cryptocurrency?

Absolutely.

Bubbles and Busts: Emotions at Work

Investors are human and subject to emotional thinking such as greed and the fear of missing out. Ben Graham was aware of this when he stated, “Individuals who cannot master their emotions are ill-suited to profit from the investment process.” Day in and day out, financial media and periodicals are shoving headlines in our faces, such as:

German President Hopes Financial Sector Stems Cryptocurrency Bubble ETH News February 2, 2018

President Frank-Walter Steinmeier spoke to 1000 guests at a Daka Bank about the responsibility the financial sector has regarding cryptocurrency.  The President stated, “Preventing new speculation acrobatics and formation of bubbles is primarily the responsibility of the financial sector.”

Amongst the world’s central banks, the majority have a “no way Jose” attitude toward cryptocurrency, whereas others are cautious and a few are optimistic. The financial sector seems very encouraging as Bitcoin futures are trading alongside old-guard futures such as hogs, wheat and corn. Also, brokers such as TD Ameritrade and Fidelity are offering future contracts and mining cryptocurrency, respectively.       

What if I’m holding cryptocurrency? Should I sell? Should I buy more? Should I just keep what I have and wait and fret?

Bubbles and Busts and Bitcoin: Gurus Fear the Worst

Predictably, the gurus think that the cryptocurrency bubble will burst and leave much financial destruction in its wake. Legendary value investor Howard Marks commented on Bitcoin, saying,

“A pyramid scheme. Serious investing consists of buying things because the price is attractive relative to intrinsic value.”

Carl Icahn, the legendary activist investor says of Bitcoin,

“I don’t understand it...If you read history books about all of these bubbles...this is what this is.”

Warren Buffett, the best value investor of all-time, commented:

Stay away from it. It’s a mirage...the idea that it has some huge intrinsic value is a joke. It’s a way of transmitting money.”The knowledge gleaned from these investors is that we should recognize bubbles for what they are and, as serious investors, avoid them.

Bubbles and Busts: One's More Attractive, One's More Profitable

There is an opposite phenomenon that value investors should be aware of, one that offers tremendous investment opportunity. Irrational exuberance drives asset prices higher than their intrinsic values during bubble periods. When economic bubbles burst they create enormous opportunities for investors as pessimism dominates market sentiment. During the bust period, when asset prices fall well below their intrinsic value, a savvy value investor can pick up good companies at deep value prices.

Buffett has spoken of his irritation during market boom periods. It is during these boom periods that buying opportunities become scarce as stock prices trade at a high premium to their intrinsic value, but when prices fall in a market decline (or a bubble bursts), buying opportunities for deep value investors arise.

Bitcoin is no different. This is what could occur when the Bitcoin bubble bursts and investors flee to the sidelines. Bitcoin itself is buckling, and has fallen from its high of $17,900 on December 15, 2017 to $6,200 on February 5, 2018. That is a 65 percent drop in a little less than 2 months.

But a falling price alone does not create opportunity.  Recognizing opportunity requires a good understanding of the true intrinsic value of the asset in question, and then buying well below that value. An investor can find many of these opportunities during market busts.

Bubbles and Busts: US Housing and Investors' Wild Ride

Take housing for example. Housing fluctuates along a sort of central value, which provides the value investor with a decent estimate of intrinsic value for homes. Using this estimate, a value investor can determine if homes in a given location are selling below intrinsic value.

Americans, convinced that home prices never decline, spent billions of extra dollars buying homes during the mid-2000s housing bubble. Home buyers took out massive loans to buy second, third, or even fourth homes, assuming that rising prices would make them rich. As we now know, many of these houses were bought without any documentation and were packaged up into derivatives that were fed to eager money managers. Housing prices soared well above the historic mean. When financial cracks began to appear, people began selling, driving home prices down to mere fractions of their original sale prices.

Warren Buffett saw the opportunity. In a 2012 CNBC interview, Buffett commented about it being an outstanding time to buy individual houses.

If I had a way of buying a couple hundred thousand single-family homes and had a way of managing them, I would load up on them. I would take mortgages out at very, very low rates. But if anybody is thinking about buying a home, five years ago they couldn’t buy them fast enough because they thought they were going to go up, and now they don’t buy them because they think they’re going to go down. It’s a very attractive asset class now.

Whether investing in equities or real estate, Buffett’s maxim is consistent: be fearful when others are greedy and greedy when others are fearful.

Bubbles and Busts: The Great Financial Crisis Was a Boon for Smart Investors

During the 2008 Financial Crisis, investors were bailing out of stocks. Solid companies like Starbucks traded below $8 per share and Priceline traded at below $50 per share. As of the Friday, February 9th, 2018 market close, Starbucks and Priceline are trading at $54 and $1,765 per share, respectively.  During the financial crisis, Buffett invested $5 billion in Goldman Sachs and helped finance Mars’s purchase of Wrigley. As of 2013 these investments yielded $10 billion in profit to the Oracle of Omaha. So as gut-wrenching as busts can be for your portfolio, they provide opportunities that can yield large future profits.

Whether using the Acquirer’s Multiple, or Ben Graham’s Net Current Asset Value (NCAV) method, mastering emotions is the order of the day. Any temptation I had toward looking at a cryptocurrency investment vanished when friends started advising me to buy Bitcoin. A few questioned my investing acumen when explaining I was abstaining from the Bitcoin mania.  I thought that funny (and I dare say a bit insulting) since these particular friends could barely understand their 401K statement without my assistance.

Value investors tend to be contrarian in nature. We do not go against the grain just to be oppositional. It is done because it is the easiest way to make money. There is logic in avoiding herd mentality, but logic is not sexy. What is sexy right now? Is it Bitcoin with its promise of fast easy wealth or a stodgy heavy-asset old economy company? What will get more press in the media? Which one will stir emotions and encourage buying and cause inflated stock prices beyond intrinsic value? The answers to these questions are obvious (hence why bubbles occur), but evaluating companies that are out of favor and not on CNBC’s business news crawl will prove itself to be the better option. These companies’ stock prices have not been goosed by irrational exuberance.

Bubbles and Busts in Individual Stocks Can Yield Great Returns

One example is Broadwind Energy (BWEN).  BWEN provides products to customers in the energy, mining, and infrastructure sectors primarily in the United States and on 1/30/17, the stock was trading at $4.02 per share. Over the next several months the stock climbed 134 percent, peaking at $9.41 per share on 4/26/17. BWEN then fell to $2.98 per share on 8/23/17, a 68 percent drop.  Note Broadwind Energy’s price to earnings ratio (P/E) and price to book ratio (p/b) versus the S&P 500 P/E and p/b ratio for the same period:

BWEN P/E ratio                                             S&P 500 P/E ratio

1/30/17                               205.90                                        23.68

4/26/17                                 19.79                                          23.23

8/23/17                                  6.94                                          23.36

BWEN P/B ratio                                             S&P 500 P/B ratio

1/30/17                                   0.89                                           2.96

4/26/17                                   1.85                                           3.04

8/23/17                                   0.63                                          3.10

The above p/b number shows how cheap the company was. Here are some news items that affected BWEN’s stock price during its 7 month ride in 2017.

January $28 million dollar tower-supply contract  and bought Red Wolf Company.

February – Earnings report. 2016 first profitable year. Orders tripled over 2015.

March – Sales estimates 16 percent over 2016. Red Wolf buy seen as positive.

May – 2017 1st quarter earnings up 20 percent. Strong results from towers. 43 cents EPS.

From January thru May, news was positive and it was reflected in the stock price and market sentiment. But good times never last long.

In June, cracks started to show as there was a backlog increase of over 100 percent vs 2016. BWEN’s 2017 tower estimate was lower than 2016.  October brought bad news via BWEN’s 3rd quarter results:

  • $17.7 million in 3rd quarter 2017, down from $27.5million same period in 2016.
  • 9 month period ending 9/30/17, net cash used in operating activities totaled $6.6 million versus net cash provided by operating activities of $17.1 million same period in 2016.
  • 2017 3rd quarter net loss of $2.2 million versus $872,000 net income same period 2016.

Broadwind Energy’s stock movement from January 2017 thru August 2017 had fundamental reasons, but market sentiment also played a major factor. If I had followed Broadwind Energy during that period, I would have seen the August drop as a possible opportunity for purchase.  I might have also waited for the third-quarter results to get a better idea of where Broadwind Energy was going.

How to Approach Bubbles and Busts for Maximum Profit

A value investor must remain steadfast in their mindset, practices and processes -- especially when it comes to bubbles and busts. These are necessary mental exercises which keep us all rooted in logic not emotion. Whether it be Bitcoin, some new tech, or the current housing bubble in Canada, a value investor will be best served avoiding bubbles in favor of evaluating bubbles for buying opportunities.

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