Overview
When I make any sort of purchase, nothing entices me more than the following two words:
“On Sale”
I’m not the type of person to make impulse purchases, so if I feel something is grossly overpriced, I will wait until its price drops or, if the price refuses to budge, find a suitable alternative. Even something as basic as food causes me to go deal hunting: anytime I find myself in a new food court I will spend at least 15 minutes going to every vendor and read their menus, comparing prices as I go.
My habit of looking for the lowest price possible is due to two reasons: partly because I’m frugal, and partly because I don’t believe in the following saying – you get what you pay for.
“You get what you pay for” is, beyond a shadow of a doubt, the saying I abhor the most. The reason I despise it so much is because of the implication that price and value are directly correlated – the value of a good or service increases commensurate with its price.
Time and time again I’ve seen people justify a ludicrous purchase by saying “you get what you pay for.”
Is a polo shirt sold by Banana Republic for $100+ of greater value than a $20 polo shirt sold by Old Navy? The reason I bring up these two companies is because they are owned by the same parent organization, Gap. I’m willing to bet that the shirt sold by Banana Republic is selling for that much simply because of the brand, and that the build quality of both shirts is more or less the same.
Of course, goods or services that cost more are generally of higher quality than cheaper alternatives, but the relationship between price and money is certainly not linear. This same issue of price vs. value can be observed in investing.
Price vs. Value – Purchasing Investments (Specifically, Securities)
If the logic of “you get what you pay for” applied to investing, there would be no need to perform security analysis – all an investor would need to do when comparing several stocks, bonds, or ETFs would be to purchase the most expensive option. Easy.
Unfortunately, that is not the case.
As I discussed in the Value Investing article, a security’s investment merit is a function of its price. A security may be speculative at one price point, but investment-grade at another. However, a desirable purchase price is only as good as the intrinsic value it is compared to.
Intrinsic value is an estimate arrived at using as much available quantitative and qualitative data as possible. Market price is what people are willing to pay for a security, whereas intrinsic value is an estimate of the perceived monetary value an investor hopes to gain.
A stock selling for $15 may prove to be a better purchase than a stock selling for $150 when intrinsic values are compared. Time and time again countless investors have made these sorts of purchases and have made lots of money as a result.
As you can see, when it comes to securities, “you get what you pay for” is almost always a moot argument. Purchasing the shares of popular companies simply because everyone else is doing so will not result in an immediately superior portfolio.
Going Against the Tide
When an investor, especially a value investor, is looking to purchase any sort of investment, their worst enemy by far is a very strong market.
At first, this may seem very counterintuitive, if not downright foolish. Why would an investor not want the market to thrive?
The distinction here is that an investor would not want to be in this sort of environment when they plan to make purchases. Someone looking to sell their investments during this period are surely going to be rewarded with significant capital gains.
Strong markets are undesirable for investors seeking to buy because many investments are most likely either fairly priced or overpriced. Every boat is lifted when the tide rises.
With respect to a value investor looking to purchase securities, a strong market presents a very acute problem because many securities are probably selling well above their intrinsic values.
A speculator, on the other hand, would be experiencing an unrivalled euphoria in a very strong market. All they need to do is pick a popular security, declare that the price will “go to the moon!”, then wait until they became overnight millionaires. If only it were that simple.
Thriving When Markets are Down
If a strong market is an investor’s worst enemy, then their greatest ally is a down market.
Again, this contrarian mindset may at first make little sense. Why would anyone want to be in the market when everything is going downhill?
Nothing makes me chuckle harder than seeing headlines such as “panic selloff causes Dow to drop”, or “fears drive market lower”, or in 2020 “surge in coronavirus cases see major indices drop.”
So many “investors” are quick to sell their holdings at the slightest sign of trouble, with their only reason being “the market is going down, so I need to dump all my holdings.”
What these “investors” fail to realize is that a down market should not be viewed as some apocalyptic event, but instead as a market-wide sale on nearly all securities.
Imagine if instead of the major headlines reporting “XYZ down 40%” or “major indices reach lowest point in the past year”, they instead reported “XYZ selling at a very attractive price right now” or “major indices are down, presenting an excellent opportunity to buy.” It’s so easy to spread fear, when in fact a little optimism and a cool head can go a long way.
One of Warren Buffett’s most cited quotes is “be fearful when others are greedy, and be greedy when others are fearful.” Lots of people shy away from financial markets in times of great duress, but the intelligent investor knows that such an environment presents an excellent opportunity to buy high-quality securities at very attractive prices.
In the aftermath of the 2007-2008 Global Financial Crisis, Warren Buffett bought some stocks during that time, with one of those purchases being Goldman Sachs. At the time, American investment banks were being shunned by all sorts of people, but Warren Buffett was able to ignore the noise and see the business strength Goldman possessed, even if their stock price took a hit.
This is not to say that every enterprise is simply being mispriced in down markets. An investment operation must be satisfied on both quantitative and qualitative grounds, and sometimes enterprises do in fact fall short of these criteria, with a major recession or market upheaval serving as the catalyst for their demise.
Bear Sterns was one of the major casualties of the Global Financial Crisis, resulting in its untimely collapse. A speculator would have seen Bear Sterns’ stock price fall then proceeded to bet the farm, simply because they assumed Bear Sterns would rebound eventually.
An investor would have noticed the very toxic balance sheet Bear Sterns had, their quickly deteriorating financials, and would have stayed very far away from the investment bank.
Investors must remember that just because a security experiences a decline in price does not mean it will rebound to a previously higher price point. A 40% decline does not equate to 40% upside potential.
Not Everything is Worth Purchasing
After reading the preceding section, you may be under the impression that I advocate buying any security during a recession, as long as you have the capital to do so.
That is not what I am trying to convey.
It’s true that recessions or other market events causing a downturn can significantly depress security prices and present purchase opportunities, but not every security will be investment worthy.
An investment must satisfy two criteria: offer safety of principal and provide an adequate return. A security can be selling for a very attractive price but not satisfy these criteria, thereby rendering it speculative.
A depressed market does not mean investors are exempt from performing thorough analysis. If anything, investors should dedicate even more time to analyze securities of interest in a down market to ensure a given enterprise is truly just a victim of circumstance but remains an inherently strong business.
The coronavirus-induced market crash earlier this year saw a major influx of people enter the stock market, specifically young people, citing that the crash presented a “generational buying opportunity.”
I am willing to bet that most of those young people are composed mostly of speculators who lack any sort of investing study or training, entering the market simply because they equate depressed prices as immediate bargains. I am also willing to bet that most of these young people simply bought any securities they could get their hands on without even reading an annual report.
In the preceding section, I brought up Mr. Buffett’s quote “be fearful when others are greedy, and be greedy when others are fearful.” But there is much more to this than meets the eye.
Earlier this year, Warren Buffett was criticized heavily for failing to make any major investments during the coronavirus-induced market frenzy, especially since Berkshire Hathaway possessed a record amount of cash at the time. Many market commentators were quick to rebuke Buffett, going so far as to question his investing ability (many people questioned his ability during the dot-com bubble; everyone knows who got the last laugh).
It can be argued that Mr. Buffett refrained from making any sort of major moves in March because what others saw as fear, he recognized as greed. A record number of people entering the stock market at the same time are all probably thinking “everyone else is scared, I’m not.”
You can see the problem here: every individual entering the market at that time believed that, relative to everyone else, they were the ones taking advantage of the depressed market. In reality, all those individuals were in fact greedy, warranting Warren Buffett’s cautious approach.
Earlier, I mentioned that I love seeing items on sale, but that does not mean I will make a purchase right away. The price may be lower, but I still ask myself if I am getting the desired amount of value in return.
Investors need to take the same approach when investing in a down market. Many securities may be selling for low prices, but those prices and the inherent business strength of an enterprise still need to be assessed.
Wrapping Up
An investor, from what I’ve seen, can become overly greedy in two ways: the allure of making significant capital gains in a strong market, or going on a buying spree when markets aren’t doing so well.
Down markets present an excellent opportunity to purchase securities for cheap, yes, but it is crucial to remember that a cheap security does not automatically lend it investment merit.
In any situation, an intelligent investor knows to keep their emotions in check, take the time to analyze the facts, and determine investment merit as objectively and rationally as possible.
Depressed markets present many opportunities to diligent investors but are filled with just as many toxic securities waiting to wreak havoc on your portfolio. An intelligent investor can distinguish between the good and the bad, and make a very prudent investment decision in an otherwise bleak situation.
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