BY BRAD BRAIN
This past week has seen some quick movement in the stock market. And I took advantage. I am not going to get into details on what I did, but I will tell you something even more important.
Why I did it.
As Warren Buffett famously said, “Be fearful when others are greedy, and greedy when others are fearful.”
This past week the stock market went a little crazy, due to the current adversarial political landscape. Investor consensus was manic depression. Stock prices plunged, including for some of my favourite businesses.
One business in particular is a money-making machine. Massively profitable. Great management team. In an indispensable industry. Already trading at an attractive level. This business makes so much money it literally generates more cash than it can intelligently use, and so it puts the surplus to both a share repurchase plan and consistent dividend increases.
When the politically-inspired pessimism hit, this stock dips by around ten percent. Note, the business has not changed. Just people’s perception of the business has changed, due to the evolving political landscape.
So what did I do?
I bought more, or course. A lot more. If I liked the business when it was trading at $100, I am going to love it if I can buy it for $90. Be greedy when others are fearful.
On the other hand, there are some extremely popular investments that I just cannot rationalize. Sure, I understand their popularity. But I don’t understand their share price.
One company in particular is valued at a stratospheric level, despite not having that great a financial picture. Its marginally profitable, and that is a recent development. It wasn’t that long ago when this company was hemorrhaging money. Its earnings are volatile, and right now the quarterly earnings are down 36%. Despite the unattractive financial metrics, the company trades at a price earnings ratio of almost $300.
Translating that into English, for every $300 that you spend, you get $1 of earnings. If that sounds like a lousy deal to you, well, I think you are right. It sounds like a lousy deal to me too.
Yet this is one of the most popular stocks on the planet. Be fearful when others are greedy.
Buffett is famous for his great insight, but realistically it can be really challenging to be a contrarian. You need to be willing to stand out from the herd in times when rational analysis gets replaced by emotion.
There is a reason why that stock I liked plunged. It was because that the world viewed the prospects with dread. People are fearful.
And when fear dominates the headlines, prices often disconnect from reality. Some investors will extrapolate worst-case scenarios indefinitely into the future. They just can’t see things ending well. They feel the pressure to sell, even if it means losing some money. In their mind they want to get out now before the lose the rest.
That is precisely when long-term investors should be paying attention. When people are willing to sell their shares in great companies to you at cheap prices.
To be clear, being greedy when others are fearful does not mean being reckless. It does not mean ignoring risk or blindly buying falling stocks. We need to distinguish between temporary uncertainty and permanent impairment. Temporary uncertainty is when a great business is out of favour. Permanent impairment is when it is not a great business in the first place.
On the other end of the spectrum is unfettered optimism, also disconnected from reality. This is when everyone agrees that an investment is going to the moon, and the pressure is to get in quick, lest we risk missing out on the next big thing.
There is a reason why that other stock, the one I avoid, is so popular. Its because the world thinks this is the future and they want a piece of the action.
Risk appears when everyone agrees on how great something is. When all you hear is how much money people are making. When people stop paying attention to the price, because everyone expects it to go even higher tomorrow.
When enthusiasm turns to euphoria, watch out. The higher the expectations climb, the less room there is for disappointment. When the price is so high that there is no margin for error, even good investments can crash quickly. And lousy investments can be wiped out.
So, the next time you see a bold headline about the stock market, keep Buffett’s wise words in mind.
Be fearful when others are greedy, and greedy when others are fearful.
Brad Brain. CFP, R.F.P., CIM, TEP is a Certified Financial Planner in Fort St John, BC. This material is prepared for general circulation and may not reflect your individual financial circumstances. Brad can be reached at www.bradbrainfinancial.com.