Why now is not the time to invest in the Dow

Now is a terrible time to invest in the Dow Jones Industrial Average, the S&P 500, Nasdaq, or any other index.  …and it’s a great time to invest in stocks.

I just finished Roger Lowenstein’s excellent book, Buffett: The Making of An American Capitalist.  This is the essential history of how Buffett made his fortune, and what is most striking is how consistent Buffett’s investment strategy has been over the decades.  In retrospect, we discover that Buffett has always been one to put his money where his mouth is.  His dedication to practicing what he preaches was perhaps most evident in the 1970s when Buffett, the lone voice for stocks in the gutted equities market, began converting massive sums of cash and bonds into stock.

His approach then is eerily familiar in light of comments he has made in recent weeks about how he decides when is the right time to buy stocks.  When is the right time?  According to Buffett, it is now.

So if now is a good time to invest in stocks, why is it a terrible time to invest in the Dow?  The short answer is that we’ve got a lot of bleeding ahead.  While I’m confident that the market will double over the next 5-7 years, I’m also confident that it could drop in half in the next 5-7 months.

The reason the market might continue to fall in the short-term is that so many companies are going out of business.  That negative pull on market indices may be enough to offset the growing enthusiasm of value investors, at least in the short term.

Luckily, there’s an out for savvy investors.  While the market as a whole will be hurt by en masse bankruptcies, a few businesses will benefit enormously from the crash.  In particular, those businesses that lose their competitors are likely to pick up massive gains in the years ahead.

Case in point: when Buffett bought the Buffalo Evening News in 1977, he was hoping to cash in on the paper’s monopolistic position as the pre-eminent newspaper in Buffalo.  The problem is that Buffalo wasn’t a one-paper town, and when Buffett’s business improvements at the Evening News threatened to close the town’s other paper, that other paper sued Buffett for antitrust violations.  The limitations imposed by the court’s injunction against Buffett caused his paper to lose roughly $10 million a year for several years.  The injunction was later over-turned, the opposing paper finally went out of business, and Buffett cleared $40 million in his first year in a one-paper town.

The market is full of opportunities just like the Buffalo Evening News, and if you’re patient enough to wait out some tough times, you’ll strike it rich.  I’m not an investment advisor, so I won’t say what those stocks are, but I’ll try to provide, briefly, the yard-sticks that Buffett seems to use when he makes his purchases.

Buffett’s entire investment philosophy boils down to three little words:

1. Character - Lowenstein writes (p.250), that Buffett believes, “that the principal judgments in business are those concerning character.”  To what extent are the officers of a company dedicated to the shareholders (vs. their own narrow interests)?  Are the officers honest?  Do they work to create a positive work environment where employees want to “tap dance” every day?  While you may not enjoy the same level of access that Buffett has to the boardroom, there are a number of ways to judge the character of an organization.
2. Moat - In business school, you learn that there are only three real competitive advantages: first, best and cheapest.  If a company can’t consistently deliver on one of these, it’s not a good investment…especially in this economy.
3. Discount - Fundamentals analysis is what separates the men from the boys.  Doing it right takes serious time.  If you’re prepared to put in the work to look beyond the PE ratio, take a look at some of the criteria Buffett applies to all his purchases.  Want a rough screen that captures some of these criteria?  Check out my Google Finance screen.

#3 is quantitative.  The other two are a mixture of qualitative and quantitative.  Even if you don’t have the instincts of a Buffett, with a little patience, you’re bound to out-perform the indices.