Overcoming your fears may allow you to capitalize on low valuations across the stock market
Buying stocks at the moment presents a number of challenges for value investors. Chief among them is the risk that Covid-19 leads to a worsening in the economy’s outlook. This could cause a stock’s price to fall after you have purchased it.
Since the financial crisis, Warren Buffett's Berkshire Hathaway has had significant exposure to financial stocks in its portfolio. Q1 2021 hedge fund letters, conferences and more At the end of March this year, Bank of America accounted for nearly 15% of the conglomerate's vast equity portfolio. Until very recently, Wells Fargo was also a prominent Read More
However, according to Oaktree Capital chairman Howard Marks it may be a good idea to focus on the stock market’s long-term recovery potential, rather than on seeking to buy stocks when they are at their lowest point. This strategy may allow you to buy stocks in the earliest stages of a bull market, and generate market-beating returns in the long run.
Finding the bottom of the market
In an ideal world, value investors would be able to identify the bottom of the market during a downturn. However, the reality is that such an aim is impossible. It is only with the benefit of hindsight that market bottoms can be pinpointed.
According to Howard Marks, a better idea than seeking to identify the stock market’s lowest point is to buy quality stocks at attractive prices:
“Like so many other things in the investment world that might be tried on the basis of certitude and precision, waiting for the bottom to start buying is a great example of folly. So, if targeting the bottom is wrong, when should you buy? The answer’s simple: when price is below intrinsic value”.
Through focusing on obtaining a wide margin of safety when buying strong businesses, you may be able to use your capital more productively than seeking to time the market’s movements.
Buying amidst investor pessimism
Buying when other investors are downbeat about the prospects for the stock market can be challenging. You may, for example, find it tough to go against the investor consensus. This can cause you to delay purchasing undervalued stocks until their margins of safety are narrower than they were previously.
Therefore, buying when investor sentiment is weak could be a profitable strategy. According to Howard Marks, buying early on in a bull market can be a productive move:
“The three stages of a bull market: the first stage, when only a few unusually perceptive people believe things will get better, the second stage, when most investors realize that improvement is actually taking place, and the third stage, when everyone concludes things will get better forever”.
Buying in the early stages of a bull market will not necessarily lead to immediately positive returns. But it could position your portfolio most effectively for a long-term recovery.
Overcoming your fears
Unearthing stocks that offer good value for money may not be the most difficult challenge for investors to overcome at the moment. Fears about losing money in the short run may be more prevalent among investors, and could mean they fail to act on buying opportunities that come along when quality stocks offer wide margins of safety.
According to Howard Marks, allowing your fear of experiencing short-term losses to supplant your bullish views regarding company fundamentals is a common occurrence:
“The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological”.
By accepting the potential for unrealized losses in the short run, and adopting a long-term view of your portfolio’s performance, it is possible to more easily capitalize on attractive valuations during a market decline.
Making room for new additions
Selling stocks during a market downturn may crystallize losses, but could provide you with an opportunity to improve the return prospects of your portfolio.
For example, a company’s prospects may now be very different to when you purchased it due to the changes induced by the Covid-19 lockdown. Therefore, selling it to make room for another stock that offers a more favorable risk/reward opportunity could be a logical step for any investor to take.
Howard Marks has previously described how he aims to build a successful portfolio of stocks:
“The process of intelligently building a portfolio consists of buying the best investments, making room for them by selling lesser ones, and staying clear of the worst”.
Selling your inferior holdings may not be a pleasant experience – particularly if it involves realizing losses. But it could provide capital to buy more attractive opportunities at a time when many stocks may prove to be undervalued.
This article was first posted on ValueWalkPremium