In our previous two articles, Choosing the businesses with strong economics- Part 1: avoiding poor economics businesses and Choosing the businesses with strong economics- Part 2: finding durable competitive advantaged businesses, you have learnt about which businesses to avoid and which ones to look out for as your investment candidates. Once you have identified such businesses, the next question is, when do you make a move to invest in them?
First, you need to have some idea how much that business is worth. Our previous articles, Measuring the value of an investment and Effects of inflation on value of investment will give the mathematical explanations on how to value a business. But do not confuse mathematical precision with accuracy. As we said before in Confusion between precision & accuracy,
As the above-mentioned analogy shows, precisely wrong numbers are useless. If we use them, then the quality of our investing decision will degrade considerably.
For this reason, it is better to be vaguely right than to be precisely wrong.
Second, you must remember this: never ever pay for more than what the business is worth. In fact, it is advisable that the price you pay be of a certain margin (say 15%) below its worth. This is to give you a margin of safety against errors in judgement.
The next step is to wait patiently, stalking the business like a hunter. Eventually, bad news will strike the business, revealing the changes that will occur. Then the stock market will typically overreact, pulling the stock price to a level that is far below what it is worth. That will be the time to strike. The stock market overreacts because it is not rational and suffers the common mental pitfalls that ail every human. To be a successful investor, you need to be more rational than the market collectively. We recommend that you familiarise yourself with the common mental pitfalls as explained in our guide, Common mental pitfalls that leads you astray and Why are the majority so wrong at the same time and in the same ways?.
However, this step is the trickiest one and errors in judgement are most likely to be made. Bad news comes in two flavours:
- Changes to the business are temporary and therefore, a recovery will eventuate in due time.
- Changes to the business are permanent and therefore, there will be no recovery.
Thus, you have to discern the nature of the changes, understanding whether the context of the underlying trends in which the business changes occur is secular or cyclical (see Understanding secular vs cyclical). For example, as we explained before in Should value investors be ?bullish? in a bear market?,
One value-oriented stock research (which we will not name) believes that this current bear market will be like any other ?typical? bear market in the past- the downturn will last only 12 to 18 months. In other words, their position is that this coming recession will only be a V-shape or U-shape recession (see What type of recession is coming?). If they are wrong about that (i.e. the coming recession is an L-shape one), then their current ?Buy? recommendation will be very wrong.
In short, not all bear market purchase will turn out to be astute if the timing is way too early.
This is where value investors are most likely to get wrong.
Tags: bad news, cyclical, mental pitfalls, recession, secular, Value Investing
