Monday, November 15, 2010

Why value investors can’t help but smile in a down market

The most common cause of low prices is pessimism - some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer. –Warren Buffett

A lot of people get upset and even panic when the prices of their stocks fall. I had a friend who constantly had to check the price of the stock he invested in every few hours, and got upset at himself when the stock’s price fell, saying that he made a mistake and that maybe he should cut his losses (While it’s fine to sell a stock if its fundamentals deteriorated, there’s absolutely no reason to sell a stock just because its price fell. But who knows, maybe he did want to sell because his stock’s fundamentals have been impaired).

Value investors on the other hand embrace down markets, as they know that the greatest opportunities are found during the bad times. Economic downturns not only allow us to pick up great assets for cheap, but also help us identify the companies that have been well-managed in terms of being well-funded and not needing to raise or borrow more money, having good control over costs and mitigating the drop in profits, avoiding serious risks, and making investments that will increase their competitive advantage and set them up for good growth when things recover.

Another thing to note is that when we invest in stocks, we are investing in small pieces of companies. So, we shouldn’t worry if the price of the stock drops, but worry only if the fundamentals of the company start to decline. Irrationality prevails in downturns, which results in the stocks of good companies being punished when the fundamentals of those companies might not really have been affected at all (some of the companies might have even taken advantage of the recession to take market share and improve their competitive advantages when assets are cheap).

The surest way to get rich is to buy great assets at fair prices, never mind cheap prices. And a market downturn (or the Santa Claus for value investors) presents us with opportunities to get invested in really top quality assets at significant discounts. So, don’t get depressed when the markets go south, but rejoice and smile, as that’s the time to invest and build a portfolio that will shamelessly mint money for you when the sun starts to shine again.

Thank you for reading, and may you always sustain good returns on your portfolio. Take care.