One tea leaf indicator that is used to get a sense of the future direction of the overall stock market is the number of stocks moving down in price. More stocks are now trading below their 200-day moving average than above it. Some investors might view this negatively, but an increasing number of stocks falling in price is a telling sign that brighter days lie ahead for deep value investors. Falling stock prices are a necessary but insufficient condition for deep value stocks to bubble up to the surface. This may seem counterintuitive to investors who desire an ever-rising stock market, but for value investors, the opportunity to find true bargains increases following a significant market decline.
One of Benjamin Graham's more aggressive value investing strategies was to purchase stocks trading below their net current asset value. If a stock was beaten down in price so far to where it traded below what a private owner would value it upon liquidation, investors could take advantage of the anomaly and scoop up the bargain. Holding a deep value stock until the market price exceeds its net current asset value has historically produced excellent returns over the long term. An ever greater number of stocks trending below their long-term moving average is consistent with a future environment conducive to deep value investing. Some percentage of stocks trading below their moving average will eventually reach a valuation level consistent with Graham's original concept of a true bargain. The chart below shows the percentage of net current asset value stocks that experienced a significant price decline before making their way into a deep value portfolio.
Source: V. Wendl, The Net Current Asset Value Approach To Stock Investing, (2013): p. 184.
As indicated in the chart, nearly 80% of all stocks lost money over the previous five-year period before entering the net current asset value portfolio. This holds true in both bull and bear market years over the 50-year-plus study period. As more stocks join the growing herd trading below their 200-day moving average, a certain percentage of them will fall to such an irrationally low price point that deep value investors might take an interest in them.
Waiting for stocks to reach a true bargain basement price level requires patience. It is a process that unfolds gradually over time. If most stocks are in a general decline, as they are currently, the evidence shows that some will continue to fall in price to a price point below net current asset value. The chart below shows the performance of a typical net current asset value stock over the five-year period of 1955-2008 before it entered the deep value portfolio. The chart is restricted to rolling five-year time periods when the overall stock market was in decline. There existed 10 overlapping five-year periods over the past 50-plus years when the stock market dropped in value.
As indicated in the chart, more than half of the stocks declined in price by more than 60% before entering the net current asset value portfolio. Over a typical five-year losing period in stocks, the ones trading below liquidation value experience close to seven times the price drop in comparison with the overall market. This unfolds over years, not months. Mr. Market is at times tenacious, forcing deep value investors to wait a long time before labeling certain stocks a true bargain.
Remaining on the lookout for a crack of light peering through the financial engineering monstrosity blocking our view of true bargains is the hallmark of a true disciple of Graham's teachings.