The uncertain economic outlook means many investors have been selling stocks, rather than buying them, over the past few months.
This strategy may mean that short-term risks are avoided, but could also lead to an opportunity cost in the long run as the stock market recovers to post new highs.
One investor who has a successful track record of buying stocks during uncertain economic periods is Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) Chairman and CEO Warren Buffett (Trades, Portfolio). His ability to capitalize on infrequent stock market falls when other investors are fearful could be a reason for Berkshire Hathaway’s 20% compounded returns between 1964 and 2019.
Capitalizing on weak investor sentiment
The stock market has rebounded sincre reaching its March lows. However, many investors are still concerned about the weak economic outlook. Evidence of this can be seen in the Vix Index, which measures fear among investors. It is currently trading around 29 points, which is more than twice its level from the start of 2020.
Buying stocks when other investors are fearful can be a means of purchasing quality companies at low prices. In some cases, they are likely to survive the short-term challenges posed by a weak economic outlook, and could therefore take part in a likely long-term economic recovery.
Buffett has previously highlighted the benefits that can be gained through buying during periods when investor sentiment is weak. He said, “Widespread fear is your friend as an investor because it serves up bargain purchases.”
Grasping opportunities
Since World War II, the Dow has experienced 14 bear markets. On average, they occur every five years. Therefore, investors are unlikely to experience a large number of opportunities during their lifetimes to buy quality stocks when they offer wide margins of safety.
This means that it is crucial to capitalize on low valuations when they occur. This could mean that you invest a large proportion of your available capital during an uncertain period, only for it to decline in value in the short run. But over the long term, the stock market’s past recoveries and 10% compounded returns since 1945 highlight the profit potential from grasping investment opportunities when other investors are running from them.
Buffett has previously discussed the importance of taking large positions in quality businesses when infrequent opportunities arise, saying, “Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble.”
Identifying quality companies
Investor sentiment toward entire sectors has been weak over the past several months. For instance, leisure companies have recorded major share price declines, with some retailers and consumers goods businesses also becoming unpopular among fearful investors.
Identifying quality businesses that are financially sound within sectors that have uncertain futures could be a means of accessing the best buying opportunities. Stronger businesses may stand a relatively good chance of surviving short-term disruption to their operating conditions, and could even expand their market share over the long run as weaker competitors report disappointing results.
Buffett has previously discussed how he uses investor sentiment toward a company to capitalize on its low valuation. He said, “The best thing that happens to us is when a great company gets into temporary trouble...We want to buy them when they're on the operating table.”
Investment potential
It is tempting during periods of economic uncertainty to invest in the best companies you can find without regard for their price levels. You may surmise that stronger businesses, which are currently viewed favorably by other investors, are more likely to survive tough trading conditions and can therefore benefit from a long-term recovery.
Buying stocks at unattractive prices, however, could be detrimental to your long-term returns. Their popularity among other investors may mean they lack a margin of safety and are less likely to produce capital growth.
Buffett has discussed his requirement for stocks to trade at attractive prices before he considers buying them. He said, “For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments”.
Disclosure: The author has no position in any stocks mentioned.
Read more here:
- Peter Lynch on Investing in an Evolving World​
- Bill Ackman on Managing Your Portfolio in a Volatile Market​
- Benjamin Graham on Trying to Predict the Stock Market's Future
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