The Last Time This Stock Was So Cheap It Rose 284%

Sep 21st, 2006 | By Penny Sleuth Contributor | Category: Investing Strategies, Macroeconomics

Dr. John Hussman is one of the great fund managers alive today. His Strategic Growth Fund has averaged a 13.39% annual gain since it was started in July 2000.

In today’s era of overhyped profit expectations, a 13% annual return may not turn most novice investors on. But to the seasoned professional, this is an accomplishment worthy of great praise.

Since July 24, 2000, the S&P 500 has averaged a negative 0.75% compounded annual return, the NASDAQ has shed 11% a year and the red-hot Russell 2000 has averaged a 7.32% gain. Hussman beat all of these indexes handily. He also soundly pummeled his peers over the same time frame.

According to Morningstar, Hussman’s Strategic Growth Fund was the best in its category over the last five years. No.1 out of 99 competing funds.

The key to Hussman’s success is threefold. He invests in companies with strong cash flows and attractive valuations. He takes an acceptable amount of risk based on the overall market climate. And he insists on long-term perspective. As he said in his latest annual report (which was just made public this past month):

“The investment objectives of the Hussman Funds are distinctly long-term and ‘full cycle’ in nature, placing very little weight on tracking the market over short periods of time.”

Hussman admits that in the short term, anything can happen. He isn’t out to beat the market in a given quarter, or even an entire year. In fact, his flagship Strategic Growth Fund underperformed the S&P 500 by 50% in 2004. While investors are quick to get up in arms about such a tragedy, Hussman was just fine with the results.

The good doctor judges his performance over a full market cycle — meaning from bull to bear market runs. After all, it is easy to make money in a bull market. Everything rises (a la 2003). But it’s much tougher to survive an ugly bear market and walk away with both your wallet and dignity intact. That’s where Hussman, and his shareholders, thrive.

When valuations are rich, Hussman hedges against the possibility of a falling market. He buys long-dated put options against the major market indexes in combination with buying great businesses on the cheap. As a result of that powerful combination, the biggest drop his fund has ever experienced was a 6.98% fallout during the bear market of 2000-02. Meanwhile, the S&P 500 fell as much as 47.41% during that same time. And the Russell 2000 fell as much as 37.94%.

Think back to 2000 for a second. How much money did you lose? Was it less than 7%? Or was it closer to the 47% fallout we saw on the S&P 500?

If you started with $10,000 in July 2000 and put that money with Hussman, you would be sitting on $21,074 today. You would have more than doubled your money. Meanwhile, that same $10,000 invested in the S&P 500 would be worth $9,564. Or said another way, even after four years of rising stock prices, you would still be down from the last bear market.

That, my friends, is the difference between losing only 7% versus 47%. So what does Hussman think about the current market environment?

Historically High Valuations

In his latest annual report, he makes it very clear that the market is not an attractive place to be right now. Despite strong earnings growth and fat profit margins over the last four years, valuations suggest the coming years will be tough — especially in the small-cap sector. Hussman says:

“During the past fiscal year, speculative interest became increasingly concentrated in small stocks with low quality as measured by stability of fundamentals such as earnings and revenues and other financial characteristics. While such companies typically experience very high volatility over the full market cycle, they have become appealing to investors speculating on a continued advance in the small-capitalization sector of the market. As a result, smaller, low-quality stocks may be particularly vulnerable, especially if profit margins contract. I have intentionally avoided such stocks, despite their periodic short-term momentum.”

In fact, Hussman goes on to declare that if you look at price-book, price-dividend and price-revenue ratios, “Valuations are at levels rarely seen in history, except during the late 1990s market bubble.” When such conditions have existed in the past, the average returns have lagged those of low-yielding Treasury bills.

Of course, the mainstream is quick to point out that corporate earnings (for S&P 500 companies) have grown double digits for the past 16 consecutive quarters. And as long as profits continue to grow, we are in no danger of a downturn — no matter what valuations are.

Maybe the mainstream is right. Maybe we should all be bullish about the future. Or maybe not…

The People Running the Businesses You Invest in Are Bearish

The latest Conference Board’s CEO Confidence Survey, a quarterly survey asking corporate leaders whether they are bullish or bearish on the economy, fell to its lowest level since 2000. In other words, despite the incredible profits their companies have been cranking out for the last four years, the men and women running those companies aren’t so sure the future will be as bright:

This chart (created by William Hester — a CFA who works with John Hussman) shows corporate CEOs’ expectations of the economy in the future (in blue) and the change in corporate profits (in red).

Notice that when corporate sentiment is strong and the blue line rises above the 50 line (which separates bullishness from bearishness), corporate profits tend to follow suit. It happened in 1980, 1990 and 2002. Likewise, when executives are worried about the economy and their respective industries, corporate profits tend to plunge in the following years. Again, you can see this play out in 1977, 1987 and 2000.

Now take a close look at the data for 2006. Notice the massive divergence between profits and expectations? Corporate profits are at an all-time high, yet the CEOs running these companies are bearish right now. How is this possible?

It’s possible because profits can’t rise at a double-digit clip forever. And with four years of ridiculous growth behind us, combined with rising interest rates and a falling U.S. dollar, corporate executives aren’t certain they can maintain this bullish trend. They are nervous.

As Hester points out, “Since 1976, when CEO optimism has risen above 55, the subsequent 12-month growth in profits has averaged 12%. When the index was below 45, indicating pessimism, profits grew at just 1.1%.”

What would your portfolio look like if all of your stocks grew only 1.1% for the next 12 months? Would you still want to hold those stocks? Something to think about…

Now, I admit, this is just one survey. It may not be entirely predictive of what’s to come for the entire stock market. But before you dismiss it altogether, check this out…

This is a chart that shows the ratio of insider purchases to sells (in blue) relative to the market’s performance (as measured by the S&P 500, in red).

Notice that insider buying and the market move in opposite directions. As the market plummets and becomes cheap, insiders (the people that run the companies you invest in) buy large positions in their stock. But as the market rises (and becomes expensive), insider buying all but dries up.

It is no coincidence that insider buying is at a six-year low right now — despite corporate profits being at a six-year high and despite the overall market rising to near-2000 highs. Quite simply, the managers running the companies we invest in know this recent earnings trend is not sustainable.

So what are you to make of all this?

Time to Be Cautious

As I have been preaching in this letter for months, now is the time to be careful. Now is the time to weed out the speculative stocks in your portfolio that are rising only because of short-term momentum. And now is the time to buy fundamentally sound companies that throw off lots of cash and are cheap relative to their peers.

As I said in the last issue of Small-Cap Strategy Report, there are hundreds of small-cap stocks worth owning — despite the overall extended market conditions. The key is to stick to your guns and invest in cash-generating, inexpensive and fundamentally sound companies with simple businesses.

Regards,

James
September 21, 2006

Penny Sleuth Contributor

The Penny Sleuth also features commentary by other financial analysts, small-cap experts, investment gurus and an array of contributors from various fields and occupations. Their diverse insights and contrarian investing ideas are hand selected by the Penny Sleuth editors.

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