Investing in times of pessimism

“The market is a pendulum that forever swings between unsustainable optimism (which makes stocks too expensive) and unjustified pessimism (which makes them too cheap). The Intelligent Investor is a realist who sells to optimists and buys from pessimists.”: Jason Zweig, The Intelligent Investor.

That’s exactly what happened in India for software services between pre-Y2K and 2001; Realty, power & infra stocks in 2008 and 2020, amidst the covid fear, the hospitality and leisure sectors.

It is proven time and again that such extreme corrections provide the best investing opportunities. Most stocks that get beaten down for no fault of theirs have value in them. However, falling from their peaks is neither a necessary nor a sufficient condition for having value. To recognize value, we have to rationally distinguish between transitionary and permanent events.

Usually, we underestimate the risk when the market is going up and miss out on opportunities when the market is going down. Optimism vs pessimism is characterized by fear of missing out in a bull run vs fear of crashing out in a bear phase.

Buying when the carnage is happening requires separating emotions from rational thinking.

Investors can use the following framework to identify the right stocks during times of pessimism:

• When no one is talking about a sector/company, when it is totally out of favour, it generally trades at a historically low valuation.
• Survivability test – can the company survive the current downturn? That will largely depend on the company’s business model, the amount of debt it has, and its cash-flow-generating ability.
• Are the insiders i.e., the founders or the management increasing their stake in times of pessimism? If yes, that’s a very positive sign. It shows their belief in the company.
• The cost-saving initiatives have the potential to permanently improve a company’s profitability.
• If a company is facing temporary demand disruption, operating at lower capacity utilization is not always a negative point. This means with the rise in demand the company can improve output without any significant requirement for capacity expansion.
• Even if the company stands true to all such parameters, if it is facing a corporate governance issue, it should be avoided. There are always better alternatives.

Conclusion: It is rewarding to be optimistic during pessimism however, one should be extremely disciplined and patient in order to reap the results. Also, sticking with the framework, setting up milestones and avoiding companies with governance issues proves very helpful.

With excerpts from: www.cfasocietyindia.org

Disclaimer: “The views expressed are for information purposes only. The information provided herein should not be considered investment advice or research recommendation. The users should rely on their own research and analysis and should consult their own investment advisors to determine the merit, risks, and suitability of the information provided.”