Review & Outlook

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Shopping from the Stock Market’s Clearance Rack

24 February, 2016 by Ben O'Brien in Commentary

Last weekend I was at a department store with my wife. While I was waiting for her to pick up some towels from our wedding registery, I wandered over to the men’s section. I wasn’t looking for anything in particular, but, always a thrifty sort, I found myself drawn to the clearance rack. There, to my delight, I came across a coat of a type that I had always admired but couldn’t bring myself to buy because of the hefty price tag. And here it was in my size and my favorite color, more than 60% off.

As I happily drove home with my new coat, I got to thinking, there must be some investment lesson here. How did I manage to get away with this great deal? Of course you always want to take advantage of bargains and sales when they are available, I thought, but how exactly do you go about it? It occurred to me that in clothes shopping or in investing in stocks there are two general approaches. You can first ask, “What do I need?” then realize you need a coat and go looking for the best deal on a coat. Or you can say, “Among the things that I might at some point conceivably need, what are the best deals out there?”

This latter perspective I call the “clearance rack” approach. Of course it doesn’t always work in shopping or in investing because sometimes you just need something and have to go out and buy it now, whatever the current price. But as far as it is possible to practice, it seems the clearance rack approach is superior. That’s where you find the great deals. It’s unlikely that there will happen to be a great deal in the thing that you happen to want most at the moment, but if you look in the clearance rack, there are always deals.

So what is the clearance rack in investment terms? Unfortunately, in the market the clearance rack is not as well marked as it as at Nordstrom’s or Macy’s, but it is there. Sometimes, in a big bull market, the bargains are harder to find, but even then they exist.  Much like the clearance rack at the department store, the market’s bargain bin is full of odd sizes and colors and last years fashions. But then again, you might find a perfectly good jacket that is being discounted because the store has excess inventory that it is trying to liquidate at the end of the season.

There are several ways to recognized the stock market’s clearance rack. You could look for high-quality companies that are likely to recover among the stocks on the 52-week low list. You could do a screen for companies with the lowest valuation multiples. Probably better than any formulaic approach though is simply reading widely and keeping your ear to the ground for any stock that’s generally high-quality but deeply out of favor in the short-term. This principal also works, of course, across different asset classes, though I have been focusing on stocks here.

So what’s in the bargain bin right now? You could start by looking at energy and materials stocks which have been pounded for the last several quarters, some more justly than others. Healthy food stocks are a once-hot sector whose massive sell-off has probably been overdone. For more exotic wares, you might delve into mortgage REITs or natural gas pipeline MLPs. I am not saying these particular ideas are sure bets, but this is the pile you need to sift through to find great buys right now. Not everything in the pile will work out, and in fact maybe a good bit of it is junk just as the clearance rack might contain a sweater with the neck hole accidentally sown shut or a set of two left-footed slippers. But if you really want a deal, this is the most promising hunting ground.

As with shopping, you need to make sure when you are getting something that you actually want. If you get a tremendous deal on a left-handed potato peeler but are right handed and don’t like potatoes, then this great bargain is actually worthless to you. Likewise, if mortgage REITs or MLPs don’t fit your level of expertise or risk tolerance, leave them in the bin for someone else.

Though it is fairly straightforward and commonsensical, the clearance rack approach is a fundamentally important frame of mind that an investor should cultivate when looking for stock ideas.