How to Invest When the Stock Market Falls

Primarily, the key risk to buying into weakness is the chance that you’ve invested in a value trap. The first step is to acknowledge the source of value traps, which tend to cluster under the following situations:

Assets undergoing structural change. This is the most common at an asset class level, which can evolve via comprehendible means – an ageing population or industry in structural decline – or via rapid disruption, that is harder to distinguish – wiped out via technological advancements.

Leveraged businesses that succumb to debt constraints. If an investment falls in price, the debt can suffocate the capital, creating the conditions for a perfectly good business to be a value trap.

Businesses with poor cashflow management. For example, undertaking a monumental capital expenditure program when there isn’t the cashflow to support it, destroying the value of the business.

The other, which is likely to have relevance today, is when assets are still expensive. This may not fit the classic definition of a value trap, but an asset going from extremely expensive to moderately expensive is unlikely to make a good investment, even if the price has fallen meaningfully.

The Risks when Buying into Weakness

The problem, of course, is that some investments can tumble into structural decline. Take Kodak for example, where many investors in the 1990’s never anticipated the progression of digital cameras, nor that Kodak would be left behind in that progression. Buying in the dips would have been a terrible idea for most investors, as you would have continually bid up this exposure only to find it halve, halve and halve again.

Underpinning the above risks, a key challenge is that ‘early’ and ‘wrong’ can sometimes be indistinguishable in the initial stages of an investment. An investor who is ‘early’ would likely prefer to increase their exposure as the probability of a turnaround increases, much like a poker player should.

However, if that investment becomes ‘wrong’ i.e. a value trap, they should consider accepting their losses and move on. It is entirely possible to be both early and wrong if the nature of the asset changes over time.

This is also a warning that cheap assets can get even cheaper. The implication for ‘buying into weakness’ is that we should understand how far valuations can stretch. For example, if an investment falls by 20%, but could fall a further 30%, 40% or 50%, we likely want to avoid going ‘all in’.

In principle, you must therefore conform to the idea that you are often early to the party. After all, you are likely buying the investment today because it is unloved and no one else wants it – yet. By undertaking this exercise, there are no guarantees someone will want it next week, month or even year. Hence the reason value investors often cherish the word ‘patience’.

Buying into Weakness

The truth is that buying into weakness is not easy and we’re very unlikely to get the perfect timing on an investment. If we do, it will require a lot of luck. However, this doesn’t mean we should ignore the opportunity as valuation-driven investors. To bring this to life, we consider the following as an important checklist.

Your Buying Checklist

Before executing on anything, ensure the thesis still stands. Never let behavioural traits like stubbornness, ignorance or fear sway an investment decision. This should apply no matter how uncomfortable it feels.

• Review every asset in a consistent manner. Stick to four pillars; 1) identify the absolute return we might expect to achieve, 2) judge the return relative to the rest of the opportunity set, 3) examine the fundamental risks that could prove us wrong, and 4) assess the sentiment towards that asset, contrarian indicators.
• Ensure the analysis includes a deep-dive on debt levels and cash-flow management. This should also consider whether an industry is undergoing a period of structural change, often seen via excessive or insufficient capital expenditure.
• Have a clear portfolio construction mandate, and where appropriate, include limits on maximum exposure. This won’t always reduce the likelihood of errors, however we believe it will help reduce the magnitude of loss. We believe portfolios should be built for multiple outcomes, not just one.
• Last, peer review all convictions and investment decisions. A committee structure, in particular, can be a constructive way to pick holes in a proposal and test the strength of the thesis.

Conclusion?

In summary, buy into weakness, but only when it makes sense to do so. The only way to know if it makes sense is to conduct rigorous checks before every buying decision. The key is to leave emotions like fear or greed aside, instead focusing on delivering long-term returns that can help you achieve your investment goals.