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Investors: Run toward, not away from, stock bargains

Index investing usually beats active managers, but Larry Sarbit is one of the few who often comes out ahead.

We've all watched in recent days as markets around the world have imploded. The reasons are front page news: the U.S. economy is growing faster than expected and therefore interest rates will be headed higher. In an investor's mind higher rates translate into lower valuations for business' earnings and thus the value of the businesses themselves. The end of the age of near-zero interest rates may very well be at hand.

Investors have irrationally gotten used to interest rates staying near these low levels for an indefinite period of time. A generation ago, stocks declined because rates were extraordinarily high and were believed to be going higher forever. Think of the late 1970s and early 1980s when rates were at stratospheric levels of 20 per cent. At that time, stocks were trading at some of the lowest valuations seen in decades. Investors' response? Don't buy any more, in fact sell what you have at those bargain valuations.

I have a guess as to what investors will do this time around. Let's assume that the current fall in equity stock prices turns into a much deeper and longer decline. Imagine stock prices have begun a large "correction" over the next several months as the realization of higher interest rates begins to sink in to the average investors' minds. What if there are some big two-day, week- or month-long deterioration in prices? What if we have a repeat of October, 1987, when the market collapsed 25 per cent in a day? There's no law to say these things can't happen again. Think of the financial disaster of 2008, still vivid in most people's memories. What will the average investor do? How will they respond?

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I will tell you exactly what the masses will do – they will act as they always have. First, they will stop buying equities and equity mutual funds. And if the decline in prices is prolonged – or stock prices remain stagnant for an extended period of time – they will accelerate their search for the exits, thus exacerbating the decline in stock prices with their sales.

You can go back in stock market history and observe very different circumstances and reasons for stocks dropping. In my investing memory, there was the hyperinflation of the late 1970s and early 80s, the crash of 1987, the S&L crisis/Gulf War of 1990 and the financial meltdown of 2007-08. The investing landscapes are all different but the response of the masses keeps repeating over and over again.

We have experienced this pattern in our current fund, the IA Clarington Sarbit U.S. Equity Fund. When markets headed higher, the asset flows were positive and rising (late 2010 and early 2011). As markets recede, fund flows dried up and for a time, turned into redemptions (third and fourth quarter 2011). Which was the exact opposite of those investors' interests.

Stop for a minute and recognize the madness of this consistent conduct. In consumers' lives, paying less for something they use on a regular basis is the desirable and rational route. Whether it is buying a car, gasoline, tuna or toilet paper, a lower price is always a better price. The lower they go, the happier consumers are and then they usually buy even more. Why else do retailers advertise that they are selling their products for bargain prices?

But in the crazy world of the stock market, there are no advertisements telling investors that stocks are on sale. The result is that the vast majority of investors do the exact opposite to their detriment. They are happier to pay higher prices for pieces of businesses (shares or equity stakes) and frightened to buy when prices are lower for the same companies. Weird but true. The stock market is the only place I know of where logic and reason do not exist. The behaviour in this world is instead ruled, at least in the short-term by emotion.

My word of advice: apply to the stock market the consumer behaviour you instinctively use every day in buying groceries and furniture. You should purchase more shares of growing businesses when they get cheaper and fewer when they are more expensive. If they get too high in price, stop buying and if even higher beyond rational levels, sell them.

In the late 1990s – after U.S. stock prices had compounded at high-teen rates from the 1982 low levels – investors accelerated their purchases of equities and equity funds, despite extreme overvaluation levels. Crazed investors bought technology and dot-com companies at levels beyond any rational levels. Meanwhile, I sat on huge levels of cash because on a rational business basis, there were no returns left to be squeezed out. And today, we find ourselves in the enviable position of having almost 40 per cent cash with the ability of buying bargains when others are panicking.

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No one can tell you with any degree of certainty where markets are going. When asked a century ago what he thought markets would do, J.P. Morgan answered: "They will fluctuate." We agree completely with this statement, even if we have no idea where they will trend in the short to midterm. Over the long haul, we can say with confidence that they are going higher – a lot higher. So if you believe that businesses will grow, that new technologies will be created to make us all more productive and efficient, that new medical breakthroughs will occur in the future, you should see lower stock prices for what they truly are – a gift to assist you in your struggle to grow your wealth. Keep thinking like you are buying tuna instead of stocks and you'll do just fine.

Larry Sarbit is CEO & Chief Investment Officer of Sarbit Advisory Services Inc.

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