Following recent market declines, some stocks are starting to look attractive from a value perspective. With so much uncertainty clouding the outlook for the global economy and companies, however, finding real value in the current market is a challenging prospect.
Rather than asking, "where should I look for value," I have been borrowing some advice from Charlie Munger (Trades, Portfolio) and inverting the question to, "what should I be avoiding?"
What should I be avoiding?
The list of business qualities to avoid can get quite long. For a start, any companies that have a lot of borrowing are always worth avoiding in highly volatile times. These companies might be profitable in good times, but when cracks start to emerge in the global economy, debt payments are missed and leverage becomes a burden that is hard to bear. While central banks around the world are acting quickly to improve liquidity and reduce interest rates, this is unlikely to be enough for the most indebted businesses.
This is especially true of any company that produces a commodity-like product. When I say commodity-like products, I mean products that have no pricing power. This includes everything from iron ore to airline tickets and surgical face masks. In times of uncertainty and economic recession, consumers and businesses care about cost above all else. If they can find something cheaper elsewhere, they'll buy it.
This trend has only accelerated over the past decade as e-commerce has taken off. In the last financial crisis, e-commerce was still in its infancy. That helped retailers with commodity-like products survive in a harsh environment. It is unlikely the same will happen this time around.
However, there will be some winners. In the commodity industry, companies with the lowest cost of production and most robust balance sheets should be able to weather the storm.
They might even come out stronger. An economic recession would remove a lot of excess capacity from the market that has built up over the past few years. That could push prices higher in the medium term. The oil industry is a good example of this scenario. Big Oil is able to navigate the current environment better than debt-ridden marginal producers.
Value roadmap
To start, it could be best to avoid any business that has substantial amounts of borrowing, no matter how cheap they might look. If the economy slumps, it is going to be challenging to meet interest costs. Moreover, if the financial system freezes up, it is going to become impossible to roll-over or refinance borrowing.
Second, it may pay to seek out companies that have a durable competitive advantage. A competitive advantage, or what Warren Buffett (Trades, Portfolio) would call a business "moat," can be anything from a strong brand to industry-leading efficiency. These qualities will help companies to weather the bad times while at the same time putting them in an excellent place to make a strong comeback.
Third, one should always consider valuation, which is something that should always be at the forefront of value investors' minds. Stocks should always be bought with a wide margin of safety to intrinsic value. This will help protect against uncertainty.
If you're looking for ideas, a great place to start would be to look at the companies that managed to navigate the Great Recession with success. There's no guarantee these businesses will be able to repeat their performance this time around. Still, their success could be an indication of a competitive advantage that will help the company endure the downturn this time around.
Read more here:
- Warren Buffett 1986 Letter: Being Greedy When Others Are Fearful
- Warren Buffett: Leverage Can Force You to Make Bad Decisions
- Should Investors Chase Dividends or Buybacks?
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