Most people would classify the stock market as irrational and volatile. Yet, it is the best pricing and discounting mechanism that we presently have. It is not perfect, but what it lacks in predictability it makes up in opportunity. The stock market tends to flow and oscillate up and down. Sometimes drastically so. It is during those oscillations that we are given opportunities to either buy low/sell high, buy high/sell low or any other combination of the said.
We will discuss exactly how the stock market works and what causes those oscillation in the later chapters, but for now we have to figure out why and how certain stocks or the overall markets can sell at a significant discount.
So, why and how are such value opportunities created?
To be honest with you there could literally be a millions of reasons of why any particular stock sells at a significant discount. It could be caused by an economic collapse, internal company infighting, product failure, management failure, fraud, management change, financial mismanagement, industry decline, new technologies, competition and so forth.
Whatever the fundamental situation is, the market always gives investors plenty of opportunities to purchase good businesses at 50-90% discounts to their value. When such opportunities present themselves, an outsized return could be generated while taking very little risk. An ultimate setup for any investor.
With that said, let’s take an in depth look at the 3 primary reasons of why various companies sell at a significant discount.
Market Factors
Most stock market indexes such as the DOW Jones have their own rate of vibration and flow. They tend to rise and fall in conjunction with the economic cycle. The market represents an overall state of financial health and growth prospects for corporate America. As such, when the overall stock market rises (Bull Market), all stocks tend to do very well. When the market falls, most stocks tend to decline as well.
While most of the time declines are not deep enough to present investors with 50-90% discounts, at certain times they are. For example, 1929, 1949, 1972, 1982, 1987, 2002 and 2009 bottoms are just a few examples of when investors could have made a killing if they would have purchased stocks at the bottom. During those times the market presented investors with a galore of stocks selling well below their intrinsic value.
Such occurrences are caused my major failure and/or panics that tend to dominate financial markets. For example, the most recent decline of 2007 – 2009 was a perfect illustration of that. Caused by a number of fundamental and cyclical factors I discuss on my blog, it ended with major panic in early 2009. With the Dow Jones below 7,000 it presented investors with an opportunity to buy hundreds of great companies/stocks selling well below their intrinsic value.
In summary, the overall market flow and human psychology tend to push stocks well below their intrinsic values at various points throughout history. At such times enterprising investors can easily pick up wonderful businesses at 50-90% discounts. Investors should not be afraid of such severe bear markets. Rather, they should be excited. The market gives them an opportunity to pick up great businesses at significant discounts, insuring a large margin of safety (low risk) and a significant return on investment in the near future.
As Warren Buffett says, “Be greedy when others are fearful and fearful when others are greedy”.
To be continued…..
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