Value Investing Shines in a Declining Market

Who's swimming naked?

When the overall market is strong, the rising tide lifts most ships.

Profitable investments are easy to come by, mistakes are not costly, and high risks seem to pay off, making them seem reasonable in retrospect.

As the saying goes, "You can't tell who's swimming naked till the tide goes out."



Torpedo stocks

A market downturn is the true test of an investment philosophy. 

Securities that have performed well in a strong market are usually those for which investors have had the highest expectations.

When these expectations are not realized, the securities, which typically have no margin of safety, can plummet.

Stocks that fit this description are sometimes referred to as "torpedo stocks," a term that describes the disastrous effect owning them. 

For example, the previous share price of a company had reflected investor expectations of high earnings growth.  When the company subsequently announced a decline in first-quarter earnings, the stock was torpedoed.



Securities owned by value investors are often unheralded or just ignored.

The securities owned by value investors are not buoyed by such high expectations.  To the contrary, they are usually unheralded or just ignored. 

In depressed financial markets, it is said, some securities are so out of favour that you cannot give them away.

Some stocks sell below net working capital per share and a few sell at less than net cash (cash on hand less all debt) per share; many stocks trade at an unusually low multiple of current earnings and cash flow and at a significant discount to book value.



A notable feature of value investing is its strong performance in periods of overall market decline. 

Whenever the financial markets fail to fully incorporate fundamental values into securities prices, an investor's margin of safety is high.

Stock and bond prices may anticipate continued poor business results, yet securities priced to reflect those depressed fundamentals may have little room to fall further. 

Moreover, securities priced as if nothing could go right stand to benefit from a change in perception.  

• If investors refocused on the strengths rather than on the difficulties, higher security prices would result.  
• When fundamentals do improve, investors could benefit both from better results and from an increased multiple applied to them. 
• The higher multiple reflected a change in investor psychology more than any fundamental developments at the company.