The stock market's recent volatility could provide buying opportunities for value investors. Many quality companies with solid balance sheets and dominant market positions now trade at low prices that could recover over the long run.
Baupost Group leader Seth Klarman (Trades, Portfolio) has previously capitalized on market downturns. His strategy of obtaining a margin of safety when investing, understanding the companies he owns and adopting a long-term view of the stock market's performance are likely to have been key reasons for the group's 20% compounded annual return since its inception in 1983.
Searching for opportunities
The S&P 500 is currently trading around 13% lower from the start of 2020. However, this does not necessarily mean there are a vast number of companies in the index that are worth buying today.
The outlook for the economy continues to be uncertain, and many industries may experience declining sales over a prolonged period. This may cause their stock prices to move lower - even if they currently trade at a discount to their long-term averages.
Therefore, value investors should be selective in deciding where to invest in a market downturn. According to Klarman:
"Sometimes a value investor will review in depth a great many potential investments without finding a single one that is sufficiently attractive. Such persistence is necessary, however, since value is often well hidden."
The uncertain economic outlook means that assessing the prospects for many companies and industries is more difficult than usual.
This may lead value investors to avoid purchasing companies, or even sell those they hold, if they are unable to quantify the risks present. For example, Warren Buffett (Trades, Portfolio) sold Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B)'s airline holdings in April due to them having extremely opaque near-term prospects.
Klarman is also an advocate of such an approach:
"Value investors will not invest in businesses that they cannot readily understand or ones they find excessively risky."
This may lead to value investors missing out on high returns for some stocks that overcome their uncertain outlooks to post rising profitability. Overall, though, this strategy can limit the risk of loss and enhance total returns.
Obtaining a margin of safety
A margin of safety is always a prerequisite for successful value investing, but is arguably even more important during volatile market conditions.
Economic downturns and recessions often lead to major change within an industry. For example, they may strengthen dominant operators or enable new entrants to gain a foothold if incumbents experience weak financial performances.
Since investors cannot consistently and accurately predict future events, they must factor in the prospect of being incorrect in their analysis. Klarman achieves this through aiming to purchase stocks when they trade below what he deems to be their intrinsic value:
"Because investing is as much an art as a science, investors need a margin of safety."
Uncertain periods for the stock market have historically not lasted forever. They can be surprisingly short, so investors may not have an extended period of time to capitalize on the low valuations they can offer.
For example, the 2008-09 bear market caused by the global financial crisis lasted for around 18 months before a bull market resumed and the S&P 500 went on to post record highs.
This acceptance that value investing opportunities may be time-limited, and a recovery is likely over the long run, has previously been discussed by Klarman:
"Many of the forces that cause securities prices to depart from underlying value are temporary."
Therefore, conducting a thorough analysis of a business and acting swiftly upon it could be the most logical means of accessing low valuations that are only available temporarily.
Disclosure: The author has no position in any stocks mentioned.
Read more here:
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This article first appeared on GuruFocus.