Incorporating the investment principles of John Templeton will help you improve your track record…
One man consistently searched for and bought neglected stocks and made a whole lot of money doing so over and over again in different markets — John Templeton. His name is now famously associated with Franklin Templeton Funds (John sold his funds to Franklin Resources in 1992). A hallmark of the Templeton way of investing was foraying into international markets at a time when doing so was not common. Constantly searching for markets that were depressed, and within them buying not the most popular stocks but those that were beaten down, was the secret of his outstanding track record spanning decades.
Point of maximum pessimism
Templeton executed his first trade in 1939 after the start of World War II. The markets had declined 39 per cent over the preceding 12 months and the outlook was gloomy. In this pessimistic environment, Templeton took a loan of $10,000 and bought as many stocks for less than $1 as he could lay his hands on. Why did he buy when the outlook was so depressing, and what was his fascination with the $1 mark?
Buying when the outlook was negative ensured that stocks were significantly undervalued. The outcome of the War, and a victory for the Allies, was by no means assured. Fear and uncertainty combined to produce an environment of “maximum pessimism”.
The market did not expect these below-$1 stocks to do well in the prevailing circumstances. Some even faced bankruptcy. Templeton recognised these problems. To counter the risk of some of his investments failing, he bought a large number of stocks: 104 in all.
Templeton was not speculating. His investment rationale was simple: during the War all companies would be expected to contribute to the “War effort”. Where others were pessimistic, Templeton realised that the War, and the massive expenditure it would entail, was just the kind of stimulus that the economy needed to pull it out of the Depression. He realised that the prospects and profitability of at least some of these beaten down stocks would improve and this would more than compensate for the losses that he would incur on stocks that failed to turn around. Templeton was proved right. Only four of the companies he invested in eventually folded up while his $10,000 investment multiplied four-fold to $40,000.
The concept of buying at maximum pessimism has been immortalised in Templeton’s own words: “Bull markets are born on pessimism, grow on scepticism, mature on optimism and die on euphoria. The time of maximum pessimism is the best time to buy and the time of maximum optimism is the best time to sell.”
How to identify a good bargain
To identify stocks, Templeton looked at the price that he would have to pay for a dollar of future earnings today against the company’s long-term earnings growth rate. This concept is today more commonly known as the PEG ratio. A lower PEG ratio signifies a better bargain. However, don’t go buying any stock with a low PEG ratio. You need to watch out for a few things: check whether the P/E ratio itself is justified: a bull market inflates the P/E ratios of most stocks. Look up the stock’s historic trading range. Second, consider whether the company can sustain the growth rate of the last few years.
Take the example of Bata India. The stock is currently trading at a PEG ratio (calculated using a five-year EPS growth rate) of only 0.4. But is it necessarily a bargain? The five-year PEG ratio is based on an earnings growth rate of 62 per cent. But if you look at the three-year EPS growth rate, it dwindles to 21 per cent. As a result, Bata’s (three-year) PEG ratio jumps to 1.22. Not such a bargain anymore!
Templeton started looking for opportunities in international markets long before others. His rationale? “It is commonsense that if you are going to search for these unusually good bargains, you wouldn’t just search in Canada. If you search just in Canada, you will find some, or if you search just in the United States, you will find some. But why not search everywhere? That’s what we’ve been doing for 40 years; we search anywhere in the world,” he explained.
Templeton launched the Templeton Growth Fund in 1954 with the objective of searching for value stocks globally. To illustrate how successful the fund has been, take a look at these numbers: a $10,000 investment in the fund at its launch would be worth $74,61,144 today (as on January 31, 2011).
By looking beyond a single market, an investor can bypass overheated economies or those with poorer growth prospects in favour of markets that are attractively valued or offer better growth prospects. For example, global investors who invested in the Indian markets even as late as in 2006 would have made a 75 per cent return by now (BSE Sensex returns). On the other hand, those focusing on a single economy, say the US, would have made a trifling 10 per cent over the same period (Dow Jones returns).
Templeton’s yardstick for identifying attractive markets was primarily the P/E ratio. Using this measure, he would zero in on a country that offered the highest concentration of cheap stocks and start looking for potential investments. Using this method, he identified Japan as a good investment destination as early as in the 1960s — long before the Japanese markets saw the phenomenal bull run of the eighties. (Incidentally, Templeton exited the Japanese market with profits long before the bubble burst).
Investors wanting to emulate Templeton’s strategy of foraying abroad should, however, be forewarned. This is one arena where you must do your homework. While investors from better-developed markets could find the lack of information and poor disclosure standards (especially in developing markets) frustrating, for the diligent global investor this could be a source of advantage: these inimical conditions would drive the casual investor away, thereby presenting him with an opportunity to scoop up bargains before the crowds discovered them.
By incorporating these tenets of Templeton’s approach — investing at the point of maximum pessimism and foraying abroad in search of bargains — you too can improve your track record.
Rules for investing the Templeton way
Invest for maximum total return: Investors often make the mistake of investing too much in fixed-income securities. This is particularly true in today’s environment where many fixed-income securities offer negative returns to investor after factoring in inflation.
Invest - do not trade or speculate: Investors are people who buy for fundamental value. Speculators are those who buy in the hope of selling later to someone at high prices.
Remain flexible and open-minded about types of investments: Never adopt permanently any type of asset or selection method. Try to stay flexible, open minded and skeptical. When any method for selecting stocks becomes popular, then switch to unpopular methods.
Buy low: One of the great ironies of the stock market is that when stocks drop in price, or “go on sale”, they attract fewer buyers. Conversely, when stocks become more expensive, they attract increasing numbers of buyers because of their popularity. To get a bargain price, you’ve got to look for where the public is most frightened or pessimistic.
When buying stocks search for bargains among quality stocks: The best bargains are not stocks whose prices are simply down the most, but rather stocks having the lowest prices in relation to possible earning power of future years. Look for companies with high profit margins, high returns on capital, and a sustainable competitive advantage.
Buy value: Not market trends or economic outlook. Too many investors focus on the market trend or economic outlook. But individual stocks can rise in a bear market and fall in a bull market. Therefore, more profit is made by focusing on value.
Diversify: The only investors who shouldn’t diversify are those who are right 100 per cent of the time. If you are diversified among different forms of wealth, nations, industries and companies, you will be safer in the long run.
Do your homework or hire an expert to help you: There is no substitute for doing your own homework on a company. At the same time, it remains a tremendous undertaking both from a time and skill standpoint to successfully purchase individual stocks for one’s own brokerage account. For this reason, you may choose to hire an expert who has a similar investment philosophy to your own.
Don’t panic: During a market correction, DO NOT PANIC. Don’t rush to sell the next day. The time to sell is before the crash, not after. Instead, study your portfolio. If you didn’t own these stocks now, would you buy them at current prices? The only reason to sell stocks after a market sell off is to buy other more attractive stocks.
Invest for the long term: One of the most common errors in selecting stocks for purchase, or for sale, is the tendency to emphasise the temporary outlook for sales and profits for the company. Avoid this temptation and invest with a long-term perspective.
There is NO free lunch: Never invest on sentiment and never invest solely on a tip. Investing requires an open mind, continuous study, and most of all, critical judgment. There are no free lunches!
Do not be too negative: Although Sir John M. Templeton coined the phrase “maximum pessimism” to explain the best time to invest, he remains one of the world’s biggest optimists. Look for bargains and opportunities during times of market malaise. You will be rewarded in the long run for not following the crowd.
Edited version of rules compiled by Lauren C. Templeton