Monday, 27 April 2020

Falling Prices can be a double-edged sword

Risk is more often in the price you pay than the stock itself.

Markets have fallen time and again because of some political or economic announcement.  Similarly, individual stocks and sectors often fall on weaker than expected earnings or unforeseen events.

During market sell-offs, the rapid decline of prices brought bargain issues that an investor could buy for a lot less than their pre-collapsed prices.

As others are selling in reaction to news reports, you can load up with value opportunities that can benefit from the subsequent price recoveries.  It is important to understand that the prices of solid companies with strong balance sheets and earnings usually recover.  If the fundamentals are sound, they always have and they always will.

From 1932 to today, the studies confirm that when bad things happen to good companies, they recover and usually quite nicely in a reasonable amount of time.  It has also been shown that high performance seems to beget lower returns, and low performance leads to higher returns in nearly all markets.  Today's worst stocks become tomorrow's best stocks and vice-versa.

Catching a falling knife

There is danger in trying to catch a falling knife, but even when stocks dropped 60% in one year, and bankruptcy and failure rates jumped fourfold, opportunities abounded.

Remember that one of the chief tenets of the value investing approach is to always maintain a margin of safety.  You can lessen the chances of buying a failure and increase your portfolio performance if you stick to the principle of margin of safety.  Don't try to catch an overpriced, cheaply made falling knife.

When stock prices fell after the bear markets, many investors were decimated.  On the other hand, value investor like Warren Buffett, was thrilled with all the bargains he found as a result of the collapse and said now was the time to invest in stocks and get rich.  The average investor and many professionals, having suffered through a bear market, wanted nothing to do with stocks and missed out on the chance to load up at these low prices.

You just had to catch the babies being thrown out with the bathwater.


1.  Buying stocks that have fallen in price and yet still offer a margin of safety has resulted in successful investments.

2.  Although many find it difficult to leave their comfort zone and buy stocks that have fallen, those of us buying cheap stock realise that the bargains are found in the sales flyers and the new low lists, not in the highfliers (popular stocks) and the new high lists.


Bear market of 1973 to 1975 Crash of the Nifty Fifty
The stock prices fell an average some 60% and many investors were decimated.  Warren Buffett in an interview with Forbes in November 1, 1974, described himself as feeling like an "oversexed guy in a harem".

Some of the large public utilities in US overcommit to nuclear power with disastrous financial results and fell into financial difficulty.  Many of them even had to file for bankruptcy to work out their difficulties.  After the Three Mile Island accident, the world interest in US nuclear power practically ground to a halt.  Few portfolio managers or individuals wanted to invest in these companies.  But those brave few who invested in Public Service New Hampshire, Gulf States Utilities, and New Mexico Power ended up with enormous returns over the balance of the decade as the  companies worked out their problems and returned to profitability.

Late 1980s and early 1990s
The fall of Drexel Burnham, the junk bond powerhouse and the implosion of the high-yield debt market, along with collapsing real estate prices, caused what is now know as the savings and loan crisis.  This crisis spread from the smaller S&Ls to the largest banks in the country.  Venerable institutions such as Bank of America and Chase Manhattan Bank fell to prices at or below their book value and had price-to-earnings ratios in the single digits.  Wells Fargo was hit particularly hard because it appeared to have significant exposure to a rapidly declining California real estate market.  Investors who did their homework and invested in banks during this time earned enormous returns over the decade that followed as the industry went through a merger boom that generously rewarded shareholders.  You just had to catch the babies being thrown out with the bathwater.

After Bill Clinton took office, he appointed his wife Hillary to head a committee on health care reform that proposed a drastic program that would have dramatically, curtailed the profits of the pharmaceutical industry.  All the leading drug company stocks declined sharply.  Companies like Johnson & Johnson, fell to a level of just 12 times earnings.  Most investors shied away from the industry.  Investors who saw the opportunity in Johnson & Johnson realised that the stock was selling for the equivalent value of the consumer products side (Band-Aids and Tylenol) of the business.  You got the prescription pharmaceutical part of J&J for free.  Once Hillary care was a ded issue, the stock of J&J and the other pharmaceutical companies brought outsized gains to investors willing to take the plunge.

9/11 disaster
After the disaster of 9/11, American Express was viewed as being too dependent on air trael, and its shares fell from the ppprevious year's high of $55 to as low as $25.  Although American Express may have been facing some travel-related struggles, it was an enormously profitable company that sold at just 12 times earnings.  Investors who realized that companies of this quality are rarely this cheap and that the income stream from the credit card business offered a margin of safety have been amply rewarded in the years since.  American Express is another example of how catching the right falling knife can sharpen returns with high-quality stock at low prices.

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