Risks in the Public Markets’ Decrease When Prices Go DOWN, Not UP.
The title of this article should make sense to all, but I have realized working in the financial industry that there are too many people who invest with the opposite philosophy. How can there be less risk when a stock is going down? Aren’t you losing money when a stock goes down? Well, this is true if you are in need of the money in the near future. If so, this article is not for you. I am writing this for the people who are willing to invest money today for the coming year/years, not months/weeks.
To start, what is a stock? It is the first right to the profits of the business but the last right during a bankruptcy. So as a stockholder, you are basically the owner of the profit engine and your returns are tied to how that profit engine does overtime. No one knows the future, but a good start to a long-lasting profit engine is a healthy business. A healthy business is one that is not in need of financing for future growth (although they still can do so), one with a healthy balance sheet (not too much debt/capital that it becomes burdensome to service), and one that has a diverse customer base. There are other important factors, but this is a good starting point.
Now lets say you find a business you like called “XYZ” and they are priced at $60/share today. You believe the business is worth $65/share so let’s say you buy 100 shares ($6,000). Your reasoning is that you think the business in 5 years from now has a good chance to be worth even more than the $65 you think it is currently worth due to a new process/product they are in the process of creating. Three months from now, the business announces a rough quarter. Let’s say the shares at this point are at $48/share. In the annoucment, they discuss the new product or process stating that development costs are going to be higher than previously expected by 10-15%, but this cost will be amortized overtime (aka a TAX benefit in years after completion). Does the stock deserve to be down 20% in a day (if it went from $60-48 then)? Could be, but it is basically the EXACT SAME BUSINESS AS IT WAS WHEN YOU THOUGHT IT WAS WORTH $65. So sure, you have a $1,000 loss today, but you invested the money for the years ahead. You did not purchase this for how the current quarter would be, so why worry about the drop? Nonetheless people still tend to worry, they get bogged down by the Fear of Losing Money. This is a dangerous mindset to be in, as I have stated in previous articles this leads to EMOTIONAL DECISION MAKING. Which in my eyes leads to some of the worst investment decisions made. If nothing material changed, there is now LESS RISK in this company, not more risk.
Sure, sometimes declining prices can be “value traps” but they are not always. Every business will spend time outside of Wall Streets’ praise. The best time to buy a company is when they are outside of the praise. As you have maybe noticed, sometimes Wall Street gets really excited about a stock or group of stocks for a long period of time. As this continues, people believe they are in the “safe thing”. Although, they don’t realize that everyone is buying this investment not for the business but because they have heard the praise radiating from “the street”. Eventually, the business is pushed to expensive levels. This is a good sign of a stocks’ risk INCREASING, not decreasing. The voting machine has rung up bids in this stock, but the amount of cash this business will receive in the future hasn’t increased materially. Once there is signs of problems occurring, a company like this can have overwhelming selling pressure. I would rather purchase this company then, instead of when everyone wants to own it. Aka, the risks are decreasing with the decreasing price.
Now this is not as easy in practice, actually it is far from easy. We all have certain things that get under our skin and losing money is one of them. Always remember this, if you invested for your future-self, the money therefore is not meant for you today. So do your best to not let the emotions get to you. This market has been a rough one as of late, but overall, there is now less risk priced into them than there was 4-5 months ago. Can things get worse? Absolutely, no one knows the future. I would say this though, some of the businesses that have been hit hard this year are at better valuations for buying than they ever have been in my career starting in early 2018. This doesn’t mean they are all worth buying, but there are opportunities to be had. Happy investing everyone!
Riley Sisson
Branch Manager, RJFS
Any opinions are those of Riley Sisson and not necessarily those of Raymond James.
There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Investing involves risk and you may incur a profit or loss regardless of strategy selected.
