Last year was a year of mixed fortunes for investors, and as such it offered a number of sound investment lessons.
1. Say no to the narrative, not the opportunity
It’s easy to get caught up in market narratives. When news flow is good and sentiment positive, investors tend to buy popular securities at any price, paying little attention to valuation and risk. When news is bad and share prices fall, fear of loss makes investors retreat – from real risks, but also those that may be unfounded or overstated.
While it is important to avoid getting swept up in prevailing hype or gloom, it is equally important not to ignore the narrative altogether. Some of the best investment opportunities can arise from strong negative narratives; in fact, they are a necessary pre-condition to finding quality companies at cheap valuations.
For example, following Brexit, the share prices of domestic-facing UK companies – which are likely to bear the brunt of any potential economic fallout – fell dramatically. While concerns about the economic implications of Brexit are understandable, it is likely that quality companies managed by able individuals will continue to be good long-term investments if bought at sufficiently cheap valuations.
2. Capitalise on cash
When such opportunities arise, you need to have the flexibility and firepower to take advantage of them. This means holding cash in the absence of attractive investment alternatives.
In addition to narratives, negative events – such as a company scandal or the resignation of a senior executive whom investors consider essential to a company’s success – also create opportunities. When the share price of such a company falls, there is often contagion to other companies in the same sector. Adverse political or economic events can have a similar impact across a whole market. These situations often create buying opportunities.
3. Don’t lock in permanent losses
If you are losing money on an investment, due to a prevailing negative narrative or a negative event, be careful not to lock in a permanent loss in your portfolio by selling prematurely or for the wrong reasons. Are you selling a good asset that is merely undergoing a bad situation? If so, the loss in share price could be temporary, and could actually be opening up a buying opportunity to obtain more shares in a good company at a lower price.
Markets go up and down and, in the short term, there is little logic to how the market reflects news and other information. So make sure your reasons for selling are sound.
4. Make sure to pay a fair price
If you are looking to capitalise on a potential buying opportunity, make sure the price at which the share is available is in fact fair. One way to determine this is to ask yourself what an astute investor would pay for the company if it were to be sold, and to translate this into the price of its shares.
Factors to consider include:
The company’s track record of financial performance – does it have a history of making good profits?
Is there a strong market for the company’s products and services, and how sustainable is this market?
What is going on in the competitive environment? Is it easy for other companies to enter the market or does the company you’re interested in have a particular competitive advantage?
Of course, these are just a few of the many questions you need to ask and calculating intrinsic value is no easy feat – it is even complicated for professionals, and sometimes they get it wrong. So, it makes sense to try to buy a share at below its theoretical intrinsic value – in this way you give yourself a margin of safety if your calculations are a little off.
South Africa is in a very uncertain political, economic and therefore investment environment, which makes short-term investment decisions difficult. However, if you stick to proven principles, it can be a good environment in which to make long-term investment decisions.