What are some great sources of investment opportunity? Source include stock market correction or panic like a bull-to-bear market switch, industry recession, business calamity, war, or structural changes? The perfect buying situation is when a stock market correction or panic is coupled with an industry recession or an individual business calamity or structural changes or war.
Recessions signal the start of great buying opportunities, for the value investor with spare cash available. Recovery time from a recession is generally anything between one to four years and during this time there are excellent buying opportunities. During recessions the manic-depressive Mr. Market goes into panic mode and out of fear offers to sell great companies often at single digit PEs. The true value investor understands that during a recession period everyone gets hurt, but the strong survive while the weak are removed from the economic landscape. Sticking to intrinsic value calculations and focusing on business fundamentals, while ignoring manic price fluctuations, allows the value investor to pick up fantastic businesses at bargain sale prices.
Recessions are so important to the value investor we will discuss it further. George Soros, the famous macro investor, observed business boom-bust cycle markets so often during his career he formulated a graphical model of it and constructed his own market theory he called reflexivity. In his market theory he does not specify the cause of such boom-bust cycles, but he speculates that they always have a political element. Government economic intervention as the cause of business cycles has been extensively written about by various authors, including those from the Austrian School of economics. They write that an extra market force (in the case the central bank of a country) can initiate an artificial, or unsustainable, economic boom. They further write that a money-induced boom contains the seeds of its own destruction, i.e. the market upturn, must by the logic of market forces set in motion, be followed by a downturn.
When markets, or the economy as a whole, are not performing optimally politicians can interpret this situation as a threat to their elected positions. If they do, they will often take corrective action to rectify the situation before it becomes a political issue during election time. One of the popular methods of stimulating economic activity is to increase the money supply. This expansion of the money supply leads to lower interest rates. In turn lower interest rates generally lead to an overconsumption in the market as well as lower discount rates (i.e. lower cost of debt thus lower weighted cost of capital). These lower discount rates in turn lead to increased business valuation calculations, or valuation inflation, and increased malinvestment to the valuation inflation.
Over-consumption and lower cost of debt leads to increased revenues, allows businesses to expand, and leads to greater profits. This process can very easily lead to a speculative bubble, i.e. from price increases due to valuation increases, to increased investor enthusiasm, to increased demand, and hence further price increases. When a bubble starts forming, substitutes for business fundamentals start to justify the politically motivated economic boom. Therefore, as fundamental data no longer justifies the boom, market participants replace fundamental analysis with fundamental substitute analysis that will support the boom. These substitutes are always consistent with the perceived new economic conditions driving the boom (e.g. stocks are values at multiples of revenue, not earnings, and growth is funded by selling stock, not executing sound business plans). This leads to a situation where a substantial gap between market behaviour, or speculation, and fundamentals forms and widens.
This ever widening gap however cannot continue indefinite and at some point the market has to correct, it has to abandon the substitutes and re-establish fundamentals. This does not happen however before the last marginal investors in the market buy in. As the old saying goes: what the wise man does in the beginning, the fool does in the end. This final marginal buying further fuels the gap and is the boom’s final push. At this point the politicians have to cool down the market bubble in order to avoid a market crash. Interest rates are raised to reduce consumption and increase discount rates, which causes valuations to decline and malinvestment to halt.
Now the actual fundamentals start to decline as a result of lack of buying and together with rising interest rates the fundamental substitute’s starts to deteriorate. This deterioration starts the investment liquidation cycle and marginal short selling. This market behaviour feeds off itself resulting in mass selling. This triggers investors to take a so called flight to quality that involves liquidating perceived risky investments in favour of government securities or precious metals to preserve the balance of their portfolios. This process typically continues until the true fundamentals decline below pre-bubble levels. As Warren Buffett says: a pin lies and wait for every bubble, and when the two eventually meet, a new wave of investors learn some very old lessons.
At this point malinvestments are liquidated and recovery of the market can begin. Fundamentals and market conditions reconcile again and economic growth can again begin. There is however the chance of recession or depression, based on the severity of the crash. Therefore, often this phase is met with a new wave of government intervention in order to shorten the duration of the correction cycle and fuel economic growth.
The second of our ideal buying opportunities is linked to business calamity. Sometimes great companies make mistakes which cause them to lose money. This creates concern in the market and their share price reflects this by declining sharply. This in turn represents a great contrarian buying opportunity. The value investor has to determine whether this is a passing calamity or irreversible damage. A company with an identifiable competitive advantage almost always has the financial durability to survive calamity. Deciding whether the calamity is correctable is important. Even more important is whether the calamity affect’s the competitive advantage of the company, in which case the investor should not consider investing. Often just one division of a company suffers a calamity, but affects the entire company. If the investor believes that management can fix the calamity or that the other divisions, with the competitive advantage, can save the company then the investor should consider investing if the price is right.
The final opportunities arise with structural changes and world events like war. Structural changes in a company, like mergers, restructuring, and reorganizations, can often affect earnings negatively and thus negatively affect the share price thereby creating buying opportunities. War, or the threat thereof, will send stock prices tumbling. The uncertainty and great potential for disaster will send fear through the entire market triggering a mass sell-off and a hoarding of cash and safe commodities like gold. This in turn disrupts the entire economy and creates great buying opportunities for the value investor who can determine which companies will recover from the ones that won’t.
Be extraordinary!
Myles Rennie
Recessions signal the start of great buying opportunities, for the value investor with spare cash available. Recovery time from a recession is generally anything between one to four years and during this time there are excellent buying opportunities. During recessions the manic-depressive Mr. Market goes into panic mode and out of fear offers to sell great companies often at single digit PEs. The true value investor understands that during a recession period everyone gets hurt, but the strong survive while the weak are removed from the economic landscape. Sticking to intrinsic value calculations and focusing on business fundamentals, while ignoring manic price fluctuations, allows the value investor to pick up fantastic businesses at bargain sale prices.
Recessions are so important to the value investor we will discuss it further. George Soros, the famous macro investor, observed business boom-bust cycle markets so often during his career he formulated a graphical model of it and constructed his own market theory he called reflexivity. In his market theory he does not specify the cause of such boom-bust cycles, but he speculates that they always have a political element. Government economic intervention as the cause of business cycles has been extensively written about by various authors, including those from the Austrian School of economics. They write that an extra market force (in the case the central bank of a country) can initiate an artificial, or unsustainable, economic boom. They further write that a money-induced boom contains the seeds of its own destruction, i.e. the market upturn, must by the logic of market forces set in motion, be followed by a downturn.
When markets, or the economy as a whole, are not performing optimally politicians can interpret this situation as a threat to their elected positions. If they do, they will often take corrective action to rectify the situation before it becomes a political issue during election time. One of the popular methods of stimulating economic activity is to increase the money supply. This expansion of the money supply leads to lower interest rates. In turn lower interest rates generally lead to an overconsumption in the market as well as lower discount rates (i.e. lower cost of debt thus lower weighted cost of capital). These lower discount rates in turn lead to increased business valuation calculations, or valuation inflation, and increased malinvestment to the valuation inflation.
Over-consumption and lower cost of debt leads to increased revenues, allows businesses to expand, and leads to greater profits. This process can very easily lead to a speculative bubble, i.e. from price increases due to valuation increases, to increased investor enthusiasm, to increased demand, and hence further price increases. When a bubble starts forming, substitutes for business fundamentals start to justify the politically motivated economic boom. Therefore, as fundamental data no longer justifies the boom, market participants replace fundamental analysis with fundamental substitute analysis that will support the boom. These substitutes are always consistent with the perceived new economic conditions driving the boom (e.g. stocks are values at multiples of revenue, not earnings, and growth is funded by selling stock, not executing sound business plans). This leads to a situation where a substantial gap between market behaviour, or speculation, and fundamentals forms and widens.
This ever widening gap however cannot continue indefinite and at some point the market has to correct, it has to abandon the substitutes and re-establish fundamentals. This does not happen however before the last marginal investors in the market buy in. As the old saying goes: what the wise man does in the beginning, the fool does in the end. This final marginal buying further fuels the gap and is the boom’s final push. At this point the politicians have to cool down the market bubble in order to avoid a market crash. Interest rates are raised to reduce consumption and increase discount rates, which causes valuations to decline and malinvestment to halt.
Now the actual fundamentals start to decline as a result of lack of buying and together with rising interest rates the fundamental substitute’s starts to deteriorate. This deterioration starts the investment liquidation cycle and marginal short selling. This market behaviour feeds off itself resulting in mass selling. This triggers investors to take a so called flight to quality that involves liquidating perceived risky investments in favour of government securities or precious metals to preserve the balance of their portfolios. This process typically continues until the true fundamentals decline below pre-bubble levels. As Warren Buffett says: a pin lies and wait for every bubble, and when the two eventually meet, a new wave of investors learn some very old lessons.
At this point malinvestments are liquidated and recovery of the market can begin. Fundamentals and market conditions reconcile again and economic growth can again begin. There is however the chance of recession or depression, based on the severity of the crash. Therefore, often this phase is met with a new wave of government intervention in order to shorten the duration of the correction cycle and fuel economic growth.
The second of our ideal buying opportunities is linked to business calamity. Sometimes great companies make mistakes which cause them to lose money. This creates concern in the market and their share price reflects this by declining sharply. This in turn represents a great contrarian buying opportunity. The value investor has to determine whether this is a passing calamity or irreversible damage. A company with an identifiable competitive advantage almost always has the financial durability to survive calamity. Deciding whether the calamity is correctable is important. Even more important is whether the calamity affect’s the competitive advantage of the company, in which case the investor should not consider investing. Often just one division of a company suffers a calamity, but affects the entire company. If the investor believes that management can fix the calamity or that the other divisions, with the competitive advantage, can save the company then the investor should consider investing if the price is right.
The final opportunities arise with structural changes and world events like war. Structural changes in a company, like mergers, restructuring, and reorganizations, can often affect earnings negatively and thus negatively affect the share price thereby creating buying opportunities. War, or the threat thereof, will send stock prices tumbling. The uncertainty and great potential for disaster will send fear through the entire market triggering a mass sell-off and a hoarding of cash and safe commodities like gold. This in turn disrupts the entire economy and creates great buying opportunities for the value investor who can determine which companies will recover from the ones that won’t.
Be extraordinary!
Myles Rennie
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