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Funds That Avoid Disaster

They buy earnings cheaply, and they're mindful of debt.

John Coumarianos, 10/14/2008

Coulda, woulda, shoulda ... you can bet that regular investors and professionals alike are rehashing the past year or so, trying to figure out where they went wrong. It's not a new exercise; bear market after bear market, similar analyses are done.

But is there an investment approach that would have avoided the past two stock market debacles? If so, do any mutual funds employ anything like it? Is it dangerously unrealistic to think that you can completely avoid all market swoons anyway? We'll address these questions below by exploring a simple investment approach advocated by Benjamin Graham, who is widely considered one of the great investing minds.

The Common Denominator
The last two market meltdowns were basically caused by excess--excessive prices in the first case and excessive debt in the second case.

In early 2000, stock prices were simply too high. Led by high-expectation technology issues, prices were inflated through the late-1990s; consider that by early 2000, the S&P 500's price/earnings ratio exceeded 40. When fine but somewhat stodgy nontech companies such as Procter & Gamble PG sport P/E ratios in the 40s, as P&G did in 2000, things have gotten a bit out of whack. (By comparison, P&G now trades at a P/E of 19, and its five-year average P/E is 22.) The market, again led by technology stocks, imploded from early 2000 through 2002, when earnings failed to meet expectations.

The most recent meltdown, over the past year or so, has been led by bank stocks. They don't typically sport high P/E or price/book ratios, but instead use huge amounts of debt or leverage. One could argue that high prices caused this meltdown as well, because obviously no price is worth paying for financial institutions that will ultimately go bankrupt. But what caused some banks to become insolvent and worthless were massive amounts of debt and bad loans on their balance sheets.

Interestingly, the past two market debacles hurt different investment styles. During the technology debacle, growth funds paying seemingly any price for earnings growth got hurt the most, while apparently more sober value funds performed relatively well. During the current crisis, however, value funds ever-attracted to the low P/Es and P/Bs of financial stocks have taken it hard on the chin. Even seasoned market observers were surprised by how little downside protection these funds can provide when they're jam-packed with debt-laden banks.

Taking a lesson from each market meltdown, perhaps a perfect investment approach would be to buy stocks with low P/Es and little, or at least not suffocating, amounts of debt. Such an approach would avoid technology at most times and avoid banks (though not all financials) at all times.PAGEBREAK

The Graham Interview
It appears entirely too facile and even downright irresponsible to argue that one should avoid the two sectors that are the poster-children for the past two market disasters. Putting entire industries of the economy off-limits hinders full diversification. And in avoiding the most recently downtrodden sectors, investors could be ruling out the cheapest stocks available.

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