Value investing is all about buying cheap stocks. Unfortunately, finding cheap stocks is easier said than done. Distinguishing between price and value is the first step in this process. Just because a particular company’s shares look cheap compared to previous price action does not mean they offer value.
If the shares were trading at $100 two years ago and are now trading at $10, and over the same period profits have fallen by 90%, and so has shareholder equity, then it’s fair to say that shares are fairly valued at the new lower price of $10.
Time to buy?
The only reason to buy after such decline would be if the company is finally starting to show signs of a turnaround. This is the standard contrarian value bet. However, the problem with this approach, and it is a problem that all investors will face at some point during their careers, is that it is impossible to pick the bottom of the market. Just because a stock has fallen by 90% from its all-time high does not mean it won’t fall another 99.9% (as has happened with many oil sector companies as they emerge from bankruptcy restructuring.)
Trying to pick the bottom is an impossible task. To add a bit more color to the process, and explain why it is inevitable that you will never be able to bottom fish correctly, I’ve picked out some quotes from famous value investors below who try and explain the process.
How to pick the bottom
“The lesson learned here is that we are never able to buy at the low. Almost every stock I’ve ever had in the portfolio has always declined after we buy it, and thankfully most usually don’t go down to this extreme, but I think it is pretty normal to have it go down and I almost expect it now.” –Â Mohnish Pabrai (Trades, Portfolio)
"You never get the high and you never get the low." –Â Walter Schloss
"While it is always tempting to try to time the market and wait for the bottom to be reached (as if it would be obvious when it arrived), such a strategy has proven over the years to be deeply flawed. Historically, little volume transacts at the bottom or on the way back up and competition from other buyers will be much greater when the market settles down and the economy begins to recover. Moreover, the price recovery from a bottom can be swift. Therefore, an investor should put money to work amidst the throes of a bear market, appreciating things will likely get worse before they get better." –Â Seth Klarman (Trades, Portfolio)
“Even in more normal markets the typical investor feels uncomfortable when he buys too soon and unhappy when he sells too soon. Yet to be a true practitioner of the buy-low-sell-high rule he must be entirely ready to do both.” –Â Benjamin Graham
“Your chances of picking the bottom of the market are very slim, but if you’re within 5% or 10%, your gains can be extraordinary.” –Â Shelby Davis
“Some people boast of selling at the top of the market and buying at the bottom – I don’t believe this can be done except by latter-day Munchausens. I have bought when things seemed low enough and sold when they seemed high enough. In that way I have managed to avoid being swept along to those wild extremes of market fluctuations which prove so disastrous.” –Â Bernard Baruch
"I can't recall ever once having seen the name of a market timer on Forbes' annual list of the richest people in the world. If it were truly possible to predict corrections, you'd think somebody would have made billions by doing it." –Â Peter Lynch
Start a free seven-day trial of Premium Membership to GuruFocus.
