In the course of some late night reading, I came across a favorite quote of value investors: “The time of maximum pessimism is the best time to buy.” Certainly you won’t find me arguing with that, but there’s something embedded in that statement that’s often overlooked: In the calm of the storm, we can all sit here and say that when the herd is losing their mind, we will sit back, analyze the facts, and make an unbiased decision. In reality, this plays out quite differently; for one, the reasons why the herd is so overwhelmingly pessimistic is often with good reason – just like it is on the long side.
The differentiation between warranted concern and maximum pessimistic (or optimistic) is that the current rationale offered by the herd takes one idea and extends it beyond its rationale limit – for example, the belief during the internet bubble was that the dot comes would undercut brick and mortar stores and come to dominate retail – resulting in a company like eToys reaching a market capitalization of more than $10 billion (two and a half times that of Toys R Us), despite reported sales of $151 million and a loss of $190 million in 1999 (Toys R Us, by comparison, reported a profit of $372 million in 1998).
Once the dust has settled, this distinction is easy to make. Of course, the same argument made for the leading online book seller, Amazon.com (AMZN), would show something quite different; even from its peak during the heights of the Internet boom, the company’s stock has increased by roughly 140% over the past twelve years (CAGR of roughly 7.5%). In real time, it’s harder to tell whether you’re looking at Amazon or eToys.
One thing that makes this task inexorably tougher is the financial media (with help from the analyst community), which is always ready to offer an explanation for any movement in the stock price; a great example is Jim Cramer, who (as I noted in a previous article) called Ron Johnson “the greatest living merchant of our time” when he was hired by J.C. Penney's (JCP) in June 2011 as the stock was around $36/share – fast forward a couple of quarters (and 30% lower in the stock price), and Mr. Cramer had suddenly decided that he saw Johnson as a snake oil salesman from the start (“over promised and under delivered”).
Even in the time since Penney’s stock bottomed, there’s been a noticeable change in the media; with the stock up more than 50% in less than two months, commentators can no longer point to their favorite piece of “evidence” – the stock price. The funny thing is that just as they are letting up with their scrutiny, investors should be becoming increasingly critical of their holding.
The point is this: investing at the point of maximum pessimism is only possible when you have taken the time to do your homework; if you don’t know the first thing about a company, I can all but guarantee that the combo of analyst target cuts, a downward sloping stock price, and noise from CNBC will be enough to keep you on the sidelines. On the other side of the coin, we have the bouts of unjustified optimism; in an article from the time of the internet bubble lambasting Warren Buffett and Berkshire Hathaway (BRK.B) for avoiding tech companies, the author makes mention of the fact that many of the companies had seen their stock price double in mere months – multiple times – without addressing the obvious question that should follow – is any of that appreciation justified by the fundamentals?
As always, investing comes down to researching the fundamentals and being patient, while taking advantage of the herd’s obsession with the short term and fear of volatility; for the investor that sticks by these tenants, you will be able to capitalize upon the point of maximum pessimism.
About the author:
As it relates to portfolio construction, my goal is to make a small number of meaningful decisions. In the words of Charlie Munger, "Patience followed by pretty aggressive conduct."
I run a concentrated portfolio, with a handful of positions accounting for the majority of my equity holdings (currently two). From the perspective of a businessman, I believe this is adequate diversification.