SPENCE Asset Management

Bargain Hunting April 2010

Investors tend to really enjoy watching stock prices go up. And strangely enough, because investors tend to not always think correctly about the implications of rising stock prices, so-called “confidence” in the stock market usually rises AFTER stock prices have risen.

Occasionally we will be asked in a social situation for a stock tip on a “bargain.” And strangely enough this happens much more frequently after prolonged market advances then after prolonged market declines.

When the markets were trading at ten year lows in the spring of 2008, the volume of requests we received for tips on “bargains” had come to a complete halt. However, as the first quarter of 2010 winds down investors are gradually growing more comfortable with the idea that the world is NOT coming to an end (at least not right away) and stocks might be a pretty good place to have wealth stored after all. And not surprisingly, requests for us to find “bargains” is starting to increase.

Let’s spend some time discussing the idea of a bargain. First off, it is our experience that the markets are usually (though not always) pretty efficient. This means that only occasionally will sellers give away a high quality asset at a “bargain” price. Most of the time, you tend to get what you pay for.

We are reminded that Wal-Mart puts thousands of items on their sales racks every week. And anyone who has sifted through the bargain rack at their local Wal-Mart soon realizes that most of the merchandise that has been marked down was put there for a reason; Wal-Mart management wanted to get rid of a less desirable item.

Our experience is that so-called “bargains” on Wall Street work pretty much the same way as the bargain rack at Wal-Mart a majority of the time. Unfortunately high quality common stocks simply cannot be found on the bargain rack very often. Occasionally, when the equity markets go completely into the tank and everything is on sale, even the highest quality merchandise can be had cheap. But this occurs very infrequently. And this happens almost always when most investors are too scared to take any action other than to SELL. It is the widespread fear leading to a buyer’s boycott that actually creates across-the-board bargain pricing.

The flipside of this story is there is always plenty of “junk” priced at a ridiculous premium on Wall Street as well as at Wal-Mart.

Let’s look at the end of March 2010. At this point in time the market for stock prices has been advancing for a significant period of time. As such, we think it would be wise to be particularly suspicious of anything still sitting on Wall Street’s “bargain rack” in the wake of the 2008-2009 financial melt down.

It might be instructive to toss in some basic philosophy from the Warren Buffett Charlie Munger team on the concept of bargains.

“In the long run, picking up shares of the struggling operations in difficult to manage industries because prices appear to be “cheap” rarely pays off. Instead, understanding that a company with real pricing power, a low capital spending business model, rational management, and the production of consistently high rates of return on shareholder’s equity are the characteristics of stocks that turn out to be “bargains,” even after appearing to be a bit “expensive,” at first and second glance. The purchase of a well-made pair of shoes that are comfortable and last decades is a bargain though rarely “cheap.” An automobile that requires minimal maintenance and repairs and holds its value well relative to other autos is the bargain though rarely “cheap.” Durable household appliances that function well under repeated day-to-day use are bargains even when they are bought at full price. Rarely are the very best quality items we use in every day life found on the bargain racks. They simply don’t have to be put there to sell. Stocks work the same way despite the fact that we all want to buy low and sell high.”

We think the trouble with deciding on how to construct a portfolio is we all have a “cheap” side to us. Everyone wants to get something really good that is also really “cheap.” However, it is only after buying a cheap appliance or cheap pair of shoes that we learn the tough lessons about what is truly expensive and what is truly cheap. Sometimes it takes hard-earned experience to learn that in the long run stocks that feature pricing power, a low capital spending business model, rational management, and the production of consistently high rates of return on shareholder’s equity, will justify seemingly higher current outlays for shares. Having patience and a deep sense of inner confidence in what quality truly is, is the anti-thesis of simply trying to go “cheap.”

The good news for now is that in the wake of the 2008-2009 financial meltdown the economy appears to be gathering a little forward momentum. The bad news is just about everything on the bargain rack is probably not much of a bargain. So in the wake of a thirteen month advance in stock prices, we realize we will have to continue to rely on patience, experience, and inner confidence, as well as resist the temptation to go “cheap.”

So, as spring moves towards summer we will still be looking carefully. Our search will continue for what our experiences have taught us are the most likely situations to be “bargains” instead of things that are “cheap.”

—Jim Spence, Eric Walton

Spence Asset Management, Inc.
2455 E. Missouri Ave. Suite C Las Cruces, NM 88001 575-556-8500

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