Investing your capital efficiently is not an easy task in this bull market. Despite an uncertain economic outlook, many stocks have risen significantly in price in the past five months so that they now trade on high valuations.
However, in my opinion, there are always buying opportunities available in all market conditions. Therefore, it is worth searching for quality companies that trade at attractive prices.
Peter Lynch has a long track record of finding favorable risk/reward investment opportunities. His focus on company balance sheets and a willingness to buy stocks within struggling industries may explain his long-term outperformance of the S&P 500.
Balance sheet strength
The uncertain economic outlook means that companies with robust balance sheets may have an advantage over their peers. For instance, they may be under less pressure to service existing debt if they have low leverage. Equally, they may find it easier to raise funds should they be required in future.
In my view, a company's balance sheet is a good starting point when assessing its investment potential. If it has a weak financial position, it may stand a lower chance of surviving difficult conditions. This could mean that you decide against buying it, or at the very least demand a much larger discount to its intrinsic value.
Lynch has always focused on company balance sheets when allocating his capital. As he once said, "If a company has a good balance sheet when I buy it, that gives me a big edge. If it doesn't turn around I can lose a third of what I invest. But if it does turn around, then I can do very well indeed."
Unpopular industries
Some sectors have become extremely popular among investors this year. For example, many technology companies have made exceptional stock price gains as their earnings forecasts have been pushed higher.
Other sectors, such as financials and energy, are facing challenging futures. This has caused them to trade at low prices that could offer buying opportunities for value investors.
Their difficult futures may also encourage stronger businesses to become more dominant at the expense of their weaker peers. Investors who can identify sound businesses in struggling sectors may benefit not only from their low prices, but from their potential to increase market share as industry prospects improve.
As Lynch once said, "As a place to invest, I'll take a lousy industry over a great industry any time. Why? Because in a lousy industry, the weak drop out and the survivors get a bigger share of the market."
A patient approach
The stock market's gains since March mean that it is likely more difficult to find undervalued stocks than it was a few months ago. Higher stock prices mean that margins of safety may be narrower than they were in the recent bear market.
Therefore, investors may need to broaden their search to a wider range of businesses to find the relatively small number of mispriced stocks that are available.
In my opinion, analyzing as many companies as possible before deciding which ones to buy is a productive use of your time. It could lead to a more efficient capital allocation, since you will be more selective in deciding which companies are purchased.
As Lynch once said, "If I look at ten companies, I may find one company that is interesting. If I look at twenty companies then I may find two. If I look at forty, I may find four. If I look at one hundred, I may find ten."
Read more here:
- Howard Marks: History Can Be a Useful Guide in Today's Market
- Charlie Munger: A Simple Strategy Can Outperform the Stock Market
- Benjamin Graham: Stick With Value Investing for the Long Term
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