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Commentary

The ABCs of Buying into Weakness

Even after a downturn, every buying decision requires fresh perspective as it can otherwise expose you to a value trap.

By Tanguy De Lauzon, Morningstar Investment Management Europe LLC and Brad Bugg, Morningstar Australasia Pty Ltd.

Key Takeaways

  • Buying into weakness often makes sense, but it is not easy and can sometimes be the wrong thing to do.
  • Every buying decision requires fresh perspective, as it can otherwise expose you to a value trap.
  • Such traps tend to cluster around certain situations. We believe structural change, rapid disruption, leverage and cashflow as the primary concerns.

“Whether we're talking about socks or stocks, I like buying quality merchandise when it is marked down”. [1]
- Warren Buffett 

Say an investor buys an asset today and it falls by 40% tomorrow. Should you buy more of it? All else being equal, you would be crazy not to buy more as long as your conviction remains. Yet, the process of ‘buying in the dips’ is beset with behavioural challenges and something every investor must consider carefully.

Primarily, the key risk to buying into weakness is the chance that you’ve invested in a value trap. The first step is to acknowledge the source of value traps, which tend to cluster under the following situations:

  • Assets undergoing structural change. This is the most common at an asset class level, which can evolve via comprehendible means (an ageing population or industry in structural decline) or via rapid disruption that is harder to distinguish (wiped out via technological advancements).
  • Leveraged businesses that succumb to debt constraints. If an investment falls in price, the debt can suffocate the capital, creating the conditions for a perfectly good business to be a value trap.
  • Businesses with poor cashflow management. For example, undertaking a monumental capital expenditure program when there isn’t the cashflow to support it, destroying the value of the business.

The other, which is likely to have relevance today, is when assets are still expensive. This may not fit the classic definition of a value trap, but an asset going from extremely expensive to moderately expensive is unlikely to make a good investment, even if the price has fallen meaningfully.

The Risks when Buying into Weakness
The problem, of course, is that some investments can tumble into structural decline. Take Kodak for example, where many investors in the 1990’s never anticipated the progression of digital cameras, nor that Kodak would be left behind in that progression. Buying in the dips would have been a terrible idea for most investors, as you would have continually bid up this exposure only to find it halve, halve and halve again.

Underpinning the above risks, a key challenge is that ‘early’ and ‘wrong’ can sometimes be indistinguishable in the initial stages of an investment. An investor who is ‘early’ would likely prefer to increase their exposure as the probability of a turnaround increases (much like a poker player should). However, if that investment becomes ‘wrong’ (a value trap), they should consider accepting their losses and move on. It is entirely possible to be both early and wrong if the nature of the asset changes over time.

This is also a warning that cheap assets can get even cheaper. The implication for ‘buying into weakness’ is that we should understand how far valuations can stretch. For example, if an investment falls by 20%, but could fall a further 30%, 40% or 50%, we likely want to avoid going ‘all in’.

In principle, you must therefore conform to the idea that you are often early to the party. After all, you are likely buying the investment today because it is unloved and no one else wants it (yet). By undertaking this exercise, there are no guarantees someone will want it next week, month or even year. Hence the reason value investors often cherish the word ‘patience’.

[1] Source: Berkshire Hathaway 2008 Shareholder letter

Since its original publication, this piece may have been edited to reflect the regulatory requirements of regions outside of the country it was originally published in.

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