The return of volatility to the markets should be a welcome sign to value investors. It means that the stocks that have been overpriced for a while will start to go back to more realistic valuations and some will dip below their intrinsic values. This time makes many people nervous because of the fear of making mistakes and losing money. The advice we always give is to stick to the plan. Don’t sell stocks already in your portfolio just because you are afraid that they will go down. Remember that a paper loss is not a real loss unless you sell the stock.
If you’ve kept up with your value investment strategy and are ready for what to do when the market is crashing this should be an exciting time. Rising markets can be challenging for a value investor because it becomes more difficult to find a deal. You may even feel that you’re missing out on a fabulous ride if you are not fully invested in a rising market. That is usually not the case with falling markets. If you can get over the fear of trying to time the bottom of the market and continue to look at the fundamentals this is the time of greatest opportunity. The trick to being successful is to focus on the fundamentals of a company and not to try to time the bottom. When the share price reflects a bargain based on your fundamental analysis that is when you should get off the sidelines and buy stocks. That is true for rising markets as well as falling markets.
There is lots of information to synthesize in investing today. The key to success is to focus on material information instead of speculation. If there is increased risk of a recession in China but the company you are investing in doesn’t have exposure to that market, then maybe the downturn you’re seeing in the share price is a result of general market sentiment instead of a material issue impacting profitability. It is important you are intimately aware of the of the company you are investing it, how it earns money, and how it’s products are made and delivered. That will help you cut through the noise and position you well to know if a tanking share price is a result of broad market sentiment or something fundamentally wrong with the company.
What to Look For in Times of Uncertainty
There are several general assumptions the you can make about which companies have the best opportunity to weather the storm and continue to be profitable in times of uncertainty. The first is market capitalization. Micro-cap companies or any company with a market cap smaller than $500 million may not have enough case on hand or access to credit to make it through down markets and as a general rule of thumb, these companies are just not worth the time it takes to find a diamond in the rough. For the $500 million to $1 billion companies they should have long history of stable free cash flow generation, otherwise these could also be less desirable. If you’re going to start filtering companies out from a list of possible investments the market cap filter is a good place to start.
Good Companies Don’t Lose Money
We’ve mentioned many times before in this blog that Free Cash Flow (FCF) is the cornerstone of value investing. If a company is not generating consistent free cash flow it doesn’t meet the definition of a value stock. For that reason you should look for companies that continue to generate positive free cash flow regardless of market conditions. It is true that the amount of FCF may decrease during down markets, but as long as it stays positive then that’s an indication that the company is well managed.
What Sectors to Look At
There are good and bad companies to invest in in just about every sector of the economy. Whether you’re looking at financial services, industrial conglomerates, or technology companies, don’t let preconceived notions of sectors undermine your investment decisions. It is true that in value investing it is often said that large companies with significant assets can sometimes be more reliable choices. Companies like Caterpillar (CAT) whose production of heavy machinery is hard to compete with might look more interesting than a software company with no tangible assets, but the fundamentals of a company are not necessarily a result of the industry they are but rather how the company is managed. So the moral of the story is to ignore sector recommendations and invest in companies because they are good investments in themselves not because they belong to a particular sector.
There are many other characteristics to look at during a market downturn, but the biggest take-away is to look for companies that have had a minimal impact to their core business.