It may seem counterintuitive to suggest that the stock market’s recent decline means that buyers of shares face lower risks. After all, share prices usually decline because investors feel the economy’s prospects are less upbeat than previously believed. However, in my opinion, and according to traditional value investing logic, falling stock prices mean that the investment appeal for many stocks has increased because their market value now factors in a wider range of potential threats.
Some of these challenges are known. For example, at the present time, they may include the impact of extreme levels of inflation and a tightening of monetary policy. However, history shows that threats are always present for investors. And, in many cases, unknowns can appear without prior warning. A notable example of this is the sudden emergence of Covid-19 in 2020 that prompted a 31% decline for the S&P 500 in just one month.
Favorable investment odds
Due to the mix of known and unknown threats facing all stocks at all times, investors who buy in a falling market that offers a greater safety margin may stack the investment odds further in their favor. Essentially, the prices they are paying offer less risk and greater potential rewards. After all, risk is the permanent loss of capital. By contrast, uncertainty can equate to high volatility and short-term paper losses that are not necessarily permanent.
This viewpoint has previously been discussed by Mohnish Pabrai (Trades, Portfolio), founder of Pabrai Investment Funds. As he once said:
“Wall Street sometimes gets confused between risk and uncertainty, and you can profit handsomely from that confusion. The low risk, high uncertainty (opportunity) gives us our most sought-after coin-toss odds. Heads, I win; tails, I don't lose much.”
A focus on quality
Indeed, high-quality companies that have solid balance sheets, favorable market positions and sound strategies are very likely to survive uncertain periods where trading conditions worsen. As a result, they are relatively low risk opportunities. Moreover, they could strengthen their market positions in such periods due to the attrition of weaker rivals. This may mean they have greater scope to grab market share and deliver higher levels of profitability during a long-term recovery.
Buying such companies when they trade at lower prices, such as during a stock market decline, may mean investors can access very attractive risk/reward opportunities. And, while their recovery is never fully guaranteed, a diversified portfolio of such holdings is very likely to enjoy a subsequent recovery.
Past performance
Although history never perfectly repeats itself, it can provide a useful guide to the future. The stock market’s past performance shows that it continually switches between periods of boom and bust. In both cases, there are overreactions among investors based on expectations that may prove to be somewhat, or wholly, inaccurate.
Investors who can use evolving consensus views about the economic outlook to buy discounted shares in high-quality companies could capitalize on the stock market’s cyclicality. With uncertainty currently high, now may be a logical time to stack the investment odds in your favor by seeking out attractive businesses while they offer good value for the money following recent share price falls.
