“Be fearful when others are greedy, and be greedy only when others are fearful.”
That was one of Berkshire Hathaway chairman Warren Buffett’s most frequently quoted aphorisms. I think about that as I consider my financial goals.
As a relatively new investor, I want my money to help me achieve things. One of my dreams is to own a home. Investing in the right fund or choosing the right stocks can help me achieve that goal faster.
Buffett’s wisdom, however, raises the following question: When is it really the right time to bet on a stock? And is buying cheap always the best way?
What does Morningstar say about buying stocks?
Alex Morozov, head of European equity research at Morningstar, explains to me that buying cheap stocks depends on the investor’s preferences and the risks he or she can accept.
“It’s difficult to make the blanket statement that everyone should invest in cheap stocks,” he says.
“You look at people depending on where they are in the investment cycle. Are they close to retirement? Are they in the accumulation phase? Are they in a mature phase of their investment?”
Morozov believes that when Morningstar analysts rate a stock as cheap, they have already examined the specific reason for doing so and carefully assessed the impact (of a rating) on the stock itself.
“We tend to push people towards quality at an attractive price rather than encouraging them to buy everything cheaply,” he says.
“Quality companies, almost by definition, tend to generate higher returns because they are high-quality companies. They can reinvest those earnings at much higher rates. They have that ability because of the structural barriers that their industries have.”
He adds that investors should pay attention to these companies because they can generate higher asset growth than companies with little or no economic moat.
What does “buying the dip” mean and should I do it?
I also asked Tineke Frikke, fund manager of Morningstar’s Silver-rated Waverton UK Equity Fund, whether investors should prioritize buying cheap stocks.
In your opinion, my question was the wrong one. Investors are not focused on the present, but on the future.
“I’ll adjust your question a little,” she says.
“What we find interesting is not the current valuation, but what it looks like in two years. We often find that market prices are efficient at the moment and balance out all the good and bad things.
“It is less efficient if you look outward (to the future). For investors who can afford to be patient, companies appear cheap in the long term.”
She also argues that cheap companies in general can have problems like debt or perhaps the specter of a shrinking core industry or sector. Companies that deliver consistently and continue to grow usually remain expensive.
“With such companies, we are waiting for the market to sell them out, then they might become a little more attractive,” she says.
“But in general, we’re more in the middle. If a company’s price is roughly the same as it has been over the last five years, that’s not unreasonable.”
“If the value is much lower, we ask ourselves: why? And if it is much higher, we have to ask ourselves whether this is justified and whether something has changed.”
And so comes Buffett’s famous adage about being greedy when the market is scared, a practice also known as “buying the dip.” Recently, investors were left reeling from a painful decline in U.S. technology stocks after a series of factors – including worse-than-expected U.S. jobs data and the Bank of Japan’s decision to raise interest rates – spooked markets. The was a good time to buy, says Frikke.
“When the overall market is weak, it’s time to buy companies you really like,” she says.
“But is now the time to bet on companies that may not survive? Probably not. When everyone loves a stock, that’s not the time to buy it. So when the market is worried, you look for good companies.”
Most important lesson: risk costs money
Another way of looking at it is to recognise that risk costs money. Zehrid Osmani, head of Martin Currie’s global long-term unconstrained investment team and manager of the Martin Currie Global Portfolio Trust, says just that.
“With any stock, there is always an equation where you have to weigh the risk against the reward,” he says.
“It’s about assessing how much of the risk a company faces is reflected in its share price,” he tells me.
This can only be assessed on a case-by-case basis so that a blanket approach does not dominate. “At the inventory level, you need to have done your homework on what the company wants to buy and what stage of the lifecycle the product is in,” he says.
What should I do now? I have learned that buying cheap stocks is not necessarily the best way to invest – and buying expensive stocks to feel safe in the crowd is not necessarily the best way to invest either.
Rather, it is important to assess the quality of a company, its long-term prospects and the risk that investors’ expectations will not be met.
One way to get a quick overview is to look at our regularly updated list of the UK’s most shorted stocks. This shows investors the fund managers who are betting against the share prices of specific companies. Or you can use Morningstar’s own data and analysis.
And to end where I started, with Buffett, who once said, “I buy on the assumption that they might close the market the next day and not reopen it for five years.”
In this scenario, the quality companies will succeed.
