The economy's 31% decline in the second quarter was its largest quarterly fall in GDP since the second world war. It meant that the economy entered a recession following its 5% fall in the first quarter, even if the stock market soon forgot about it.
Due to a weak economy and sky-high valuations, some investors may determine that now is not the right time to buy stocks. However, I think that an opaque economic outlook can provide even more attractive buying opportunities for long-term value investors. Valuations are often lower in periods of economic stress, and this is actually no exception now - while some sectors are overvalued, others are still in the doghouse. This could mean higher capital returns as the economy recovers over the long run.
Peter Lynch frequently purchased stocks when other investors were downbeat about their prospects. His bullish long-term viewpoint regarding the stock market's outlook and a focus on company fundamentals could be key reasons for his Magellan Fund's 29% compounded returns between 1977 and 1990.
Low valuations
A recession and an uncertain economic outlook can cause some industries to become unpopular among investors. For instance, sectors such as oil and gas, financial services and leisure may currently be out-of-favour with investors due to the challenging trading conditions that they face. Investors may prefer to purchase companies that have more upbeat earnings forecasts over the short run.
In my opinion, this creates opportunities for long-term value investors. Investing in unpopular stocks can lead to an efficient capital allocation because they often trade at relatively wide discounts to their intrinsic values. This can reduce their risk because the challenges they face may have already been accounted for via low stock prices.
As Lynch once said, "My routine is always the same. I search for companies that are undervalued, and I usually find them in sectors or industries that are out of favour."
Buying companies with sound financials
Economic challenges can create major financial difficulties for companies in a range of sectors. Therefore, investors may determine that they should be avoided due to the risk of them failing to survive a period of weak trading conditions.
However, in my opinion, firms with strong balance sheets can use a period of economic weakness to their advantage. For instance, they may be able to survive challenging conditions better than their peers. This may allow them to increase their market share at the expense of weaker rivals and benefit to a greater extent from a long-term economic recovery.
Investing in companies with large cash balances, low debt and access to credit should it be needed could lead to a more efficient capital allocation. As Lynch once said, "Never invest in a company without understanding its finances. The biggest losses in stocks come from companies with poor balance sheets. Always look at the balance sheet to see if a company is solvent before you risk your money on it."
Improving expectations
The economy's recovery from a tough 2020 calendar year may not be a smooth process. It could take an extended period of time for trading conditions in sectors such as leisure, energy and banking to improve so that incumbent firms can deliver higher levels of profit.
However, it may not require a large increase in profitability to catalyze market sentiment towards stocks that operate in unpopular sectors. Investors may react positively to even a modest improvement in trading conditions that has the potential to produce growing earnings in the long run.
Investors who buy stocks prior to improved trading conditions and while economic uncertainty is highest may gain the most from them. As Lynch once said, "Even when a company just moves up from doing mediocre business to doing fair business, you can make money."
Read more here:
- Howard Marks: An Uncertain Outlook Can Produce Buying Opportunities
- Warren Buffett: A 'Dull' Investment Strategy Can Be Profitable
- Benjamin Graham: Ignoring Your Peers Can Pay off in the Long Run
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