Rising unemployment figures and weak business confidence suggest the economy faces a challenging period that may culminate in a recession. This could cause further volatility across the stock market, but may also offer buying opportunities for long-term value investors, in my opinion.
Baupost Group co-chairman Seth Klarman (Trades, Portfolio) has a long track record of taking advantage of economic weakness to generate high returns. His ability to capitalize on the stock market’s cyclicality and adapt to a changing economic outlook are likely important reasons for his 20% annualized returns since Baupost Group was formed in 1983.
Inefficient markets
The recent stock market crash may reflect a challenging economic future that leads to difficult operating conditions for many businesses. However, the stock market does a relatively poor job of accommodating the long-term return prospects for investors.
A key reason for this is the emotions displayed by investors. They have historically overreacted to bearish and bullish economic outlooks, which means that the stock market is inefficient. This view has previously been discussed by Klarman, who once said, "I think markets will never be efficient because of human nature.”
Inefficient markets provide long-term value investors with opportunities to capitalize on mispriced stocks through buying them when the economic outlook is at its worst and investor sentiment is at its weakest.
Updating your views
A possible recession in 2020 could cause significant change for many industries. For example, it has the potential to hurt weaker businesses with relatively fragile balance sheets to a greater extent than their sector peers.
This may cause the prospects for your holdings to change significantly in a short space of time. Therefore, it may be prudent to refresh your portfolio through selling those companies that no longer offer favorable risk/reward investing opportunities.
This ability to act decisively when apportioning your capital effectively during a recession could enable you to capitalize on a changing economic outlook. It is a strategy that Karman has previously utilized. As Klarman once said, "In investing it is never wrong to change your mind. It is only wrong to change your mind and do nothing about it.”
Undertaking adequate research
It can be tempting to buy a large number of stocks when they are currently trading at lower prices than they have done for many years. Investors may view this as a sound strategy due to its diversification benefits during an uncertain period for many industries.
However, this view must be balanced against a need for investors to fully understand the business models of the companies they are purchasing. For instance, they should conduct thorough research into a company’s strategy during difficult operating conditions, as well as its financial capacity to survive a period of lower sales growth.
Klarman has adopted a strategy that apportions most of his capital towards his best ideas, in terms of the companies in which he has detailed knowledge:
"My view is that an investor is better off knowing a lot about a few investments than knowing a little about each of a great many holdings. One's very best ideas are likely to generate higher returns for a given level of risk than one's hundredth or thousandth best idea.”
Focusing on value
It may be tempting to simply buy the strongest companies in a specific sector during a period of economic weakness. Investors may surmise that they offer the lowest risk and the greatest chance of survival.
However, it is crucial to consider the prices at which those companies are trading. If, for example, they lack a margin of safety, then they may be unattractive from an investment perspective relative to their sector peers.
Klarman previously highlighted that he has three buckets into which he places potential stock purchases:
"To a value investor, investments come in three varieties: undervalued at one price, fairly valued at another price, and overvalued at still some higher price. The goal is to buy the first, avoid the second, and sell the third.”
Read more here:
- Adopting a Successful Investing Mindset in the Current Crisis
- Charlie Munger on Identifying the Best Buying Opportunities
- Howard Marks' Advice on Buying Unpopular Stocks
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