The economy’s challenging outlook means that many companies face tough trading conditions. This could weaken investor sentiment towards them and cause their prices to trade at lower levels.
Investing gurus such as Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) chairman Warren Buffett (Trades, Portfolio) have previously capitalized on similar economic conditions to buy quality companies when they trade at low prices.
Likewise, Benjamin Graham and Seth Klarman (Trades, Portfolio) have focused on buying businesses with sound fundamentals when weak investor sentiment has caused their prices to become more attractive.
In my view, their ability to invest when temporary risks have caused stock prices to fall is a key reason for their long-term outperformance of the stock market.
A long-term view
The uncertain economic outlook may dissuade some investors from buying stocks at the moment. They may even decide to sell their existing holdings to avoid potential price declines as rising unemployment and weak business sentiment weigh on stock valuations.
However, low stock prices are likely to be temporary for quality companies. Over time, their valuations are likely to recover as investor sentiment and the economy’s prospects improve.
Therefore, taking a long-term view of your holdings could allow for the efficient allocation of your capital. It may increase your capacity to buy stocks when they are low today, hold them through what could be a difficult period for many sectors, and experience a recovery over the long run.
Buffett has previously highlighted his long-term stance, which has allowed him to capitalize on low stock market valuations and has been a key reason for Berkshire Hathaway’s 20% annualized returns since 1965. As Buffett once said, “If you aren’t thinking about owning a stock for 10 years, don’t even think about owning it for 10 minutes.”
A margin of safety
Forecasting the future performance of the economy is impossible. Therefore, obtaining a margin of safety when buying any stock could be a simple but effective means of reducing your risk of loss.
A margin of safety ensures there is a "buffer" in case the economy’s outlook deteriorates further and causes the trading conditions for businesses to temporarily decline. It can also lead to higher returns in the long run, since value investors demand a more attractive price when adding new stocks to their portfolio.
At the moment, there are a few sectors such as energy, consumer goods and leisure, that face uncertain economic conditions. In some cases, quality companies operating within those industries trade on low valuations that suggest they could offer wide margins of safety for long-term investors.
As the father of value investing, Benjamin Graham, once said, “High valuations entail high risks.”
A value investing mindset
A challenging economic outlook can cause some companies to go bankrupt. However, it may also lead to an improved competitive position for other businesses that can successfully adapt to changing conditions.
Therefore, allocating capital to companies with sound financial positions through the use of a value investing strategy can reduce your overall risks.
Value investors who rely on company fundamentals to apportion their capital may also be less likely to listen to the views of the crowds. Other investors can be overly reliant on their emotions when deciding how to manage their portfolios. This may mean they make inefficient investment decisions.
Baupost Group co-founder Seth Klarman (Trades, Portfolio) has previously highlighted the benefits of using a value investing strategy to manage risks and maximize returns:
“While some might mistakenly consider value investing a mechanical tool for identifying bargains, it is actually a comprehensive investment philosophy that emphasizes the need to perform in-depth fundamental analysis, pursue long-term investment results, limit risk, and resist crowd psychology.”
Disclosure: The author has no position in any stocks mentioned.
Read more here:
- Charlie Munger on the Value of Efficiency
- Howard Marks on Generating Market-Beating Returns
- Warren Buffett on Investing When Opportunities Are Scarce
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