The trading bells ring and yet another record high has been made. Now, being the disciplined value investor you are, you remember the countless words of caution about how you should be extremely wary when markets valuations are high.
Several self-proclaimed oracles are beginning to forecast about the impending doom the financial markets are heading towards. Valuations are back to pre-crisis levels. The media chanting daily about how we are in the longest bull run ever. You could almost feel the big market correction heading your way and yet what your gut is inclined to do is probably not the best course of action for your investment career. Hence, what does a deep value investor do when market valuations are exuberant?
Market timing is an attempt to profit from bull markets while avoiding or shorting the bear market when prices tank.
Many investors time the market, unknowingly or not, due to a lack of emotional self-control or delusional behaviors. Many are driven by greed and fear in an attempt to time the market.
The allure of an additional returns as a result of successful market timing draws many investors into speculation. However, what they fail to see is the huge amount of risks and frictional costs associated with such behavior. Over the long run, the additional returns you achieved from going in and out of the market may be slowly eroded by transactional costs.
Adapted from an article on Forbes, consider the chart below. You probably think that you have a good idea about when you should buy or sell.
Naturally, you would sell when its high and buy when prices dip. Right?
Perhaps, if you have learnt a thing or two about technical analysis, you are able to draw trendlines and channels below:
However, the graph above is constructed randomly and is just a series created by a random generator. It is equally possible for the ticker to head north than to head south.
What this shows is that our brains are wired to look for patterns and trends even though none is there to begin with. It is a natural instinct that we have developed over generations in order to perform our tasks more efficiently. However, this may not necessarily be the brightest thing to do in the financial market for a deep value investor.
“If I shouldn’t time the market, what can I do when prices are extremely high?”
If you have been following our blog very closely, you would know that it does not matter what the market does, what truly matters is what you do. Having chosen high quality deep value stocks that have clean balance sheets and robust cashflows, even if prices eventually head south, you need not be worried at all.
The intrinsic value of the company is like the gravity pulling the stock prices towards itself. The stock price is like a pendulum, swinging between extreme optimism and pessimism. However, on average, it will be at its intrinsic value.
Swinging towards extreme pessimism would only mean that Mr. Market is offering you a buying opportunity to enter so that you will reap the results of having remained calm and clear headed in due time.
During times of market depression, the financial markets will offer you amazing bargains of quality companies. Being aware the stock prices reflect sentiments of the future prospect, valuation ratios such as price/earnings, price/cash flow and price/book value are often nearing its lowest point.
As we can observe from the above chart, the financial crisis in 2007 offered investors a wonderful opportunity to purchase bargain stocks on a price to book basis.
This also provides a fine example of how understanding the concept of mean reversion can add value your investing decisions. Remember the pendulum analogy we mentioned before? Price to book ratio offers us an indication of the position of the pendulum at any particular point in time. This will give us a good idea of the valuation of the companies.
Value investing isn’t just about buying stocks that are cheap and sell when they are high. It requires a lot of patience, discipline and insight. Your journey in becoming a deep value investing doesn’t have to be a lonely one. We believe that by spreading and sharing these valuable nuggets of information with you, we are able to empower you to make better-informed investment decisions.
Before you put in your hard-earned cash in your first investment, we strongly encourage you to take a look at this article about how value investors should be viewing risk!