Undervalued stocks can still lose 70%

Undervalued stocks can still lose 70%

My portfolio consists of many undervalued stocks which I could argue were worth at least double their current prices. Despite this, I always wondered how they might fare in a 1929 type crash.

If you hadn’t guessed by now, I’m a value investor. Why? It’s a time-tested strategy and it has made people from Graham and Doddsville an awful lot of money. Its methodology is intelligent and based on fundamental business analysis. I urge all Money Generation XYZ readers to follow this system of investing and ignore everything else. Forget binary trading, overlook Fibonacci retracements and don’t time the market. Just focus on companies with fortress-like balance sheets, strong historical earnings and a durable economic moat trading at a discount to fair value.

Discover whether you are an investor or a speculator, here.

Undervalued stocks during a crash

To see how value investing performed during 1929 I had to turn to the old testament of value investing: Benjamin Graham’s and David Dodd’s Security Analysis. Here’s a window into the life of a value investor in 1929.

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Graham was convinced that, because his stocks were worth less than the cash on the companies’ balance sheets, he couldn’t be harmed by the impending crash which he foresaw. So much so, that he used leverage to amplify his potential returns. In 1929 Graham lost 20% of his partnership’s capital – pretty impressive all things considered – another 50% in 1930, 16% in 1931 and 3% in 1932. A cumulative loss of roughly 70%.

“I blamed myself not so much for my failure to protect myself against the disaster I had been predicting, as for having slipped into an extravagant way of life which I hadn’t the temperament or capacity to enjoy. I quickly convinced myself that the true key to material happiness lay in a modest standard of living which could be achieved with little difficulty under almost all economic conditions.”

– Benjamin Graham.

There are tons of lessons here. It certainly shows that a large margin of safety cannot protect against a crash. Here are a few tips to counter the mistakes that Benjamin made back in 1929.

 Live within your means

Ask yourself, if my portfolio dropped by 70% tomorrow then I would I care? I wouldn’t. I’m still entitled to the same earnings as before and my ownership of the company hasn’t changed. I am mentally and financially well placed to cope with such market extremities but they will certainly be testing times if you aren’t.

Before you invest, set aside capital to cover between 3-6 months of bills in the event that you lose your job. For me, this buffer is £3,600. This sounds like a lot now but as you grow your net worth it’ll be a smaller proportion. Save like a pro and you’ll have that money in no time. Try not to buy a car on finance either, it’s a sure-fire way to erode your potential savings and adds an extra layer of risk to your situation.

 Never use leverage

Leverage no doubt amplified Graham’s losses. Debt masquerades itself as the answer to bountiful returns when times are good and reveals itself as the devil in disguise when times turn bad. Times will always turn bad. Investing on a margin will drive you to make really irrational investment decisions. See what Warren Buffett says about leverage here. If you want no assets, then leverage up baby!

Warren Buffett leverage quote

Materialism isn’t the answer to happiness

Buying that car on finance, that expensive watch or that big house with a 5% deposit is fine but it will offer very little satisfaction in the long run. When things go belly up they will cause a strain on the important things in life such as your relationships and mental well-being.

Money can certainly play a role in happiness and stop a poor standard of living but there is a threshold according to behavioral economists. Focus on living comfortably and drawing happiness from the people and the world around you.

Collect moments not things - materialism

Don’t time the market, position yourself

Look, what’s the point in standing on the side-lines of the market in the case of a crash? One day you will be right but you would have been wrong every day for the last 10 years. Graham predicted a market crash but he did not protect his portfolio or his personal finances. That’s where he went wrong. A crash may destroy the value of your portfolio regardless of whether it’s undervalued or not.

To be fair to Graham, he didn’t know that his undervalued stocks would crash just as hard as everything else. He had an excuse – we don’t…

Ned stark meme "brace yourself"

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Summary
Photo ofBenjamin Graham
Name
Benjamin Graham
Nickname
(Graham)
Job Title
Value Investor
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