Emotions play a very big role in investing, but so does logic.
In finance we often hear people say, “buy low, sell high” or “buy cheap stocks and sell expensive stocks”. You cannot fault the logic. It appeals to common sense, it makes intuitive sense and it should be a profitable strategy.
But it is worth pondering how the stock became cheap or how the stock you want to sell became so expensive. Surely if everyone is using the same logic of buying low and selling high, stocks should not get cheap or expensive.
Add to this the academic research that teaches us markets are efficient and incorporate all information that exists about a stock at any given time.
On the basis that markets are efficient, if a stock is cheap there is a very good reason and if a stock is expensive there is also a very good reason. This logic would suggest there is very little chance of outperforming the market. Our academic training tells us that stocks react to fundamental information and track a company’s earnings and cashflows.
However, emotion plays a very important role when investing in the sharemarket. The market consists of thousands of individual investors who are responding daily to the emotions of hope, fear and greed.
Investors collectively swing from optimism to pessimism, back to optimism and back to pessimism again. We refer to these extremes of emotion in the market as “points of maximum optimism” and “points of maximum pessimism”.
These strong emotions can be a contributing factor to a stock becoming cheap or expensive. In extreme circumstances investors are also known to “throw the baby out with the bath water” or just plain panic.
Authors have written countless books on panics and manias, and many more authors have written books predicting these. The irony is that it is very often the process of panic or mania that creates cheap and expensive stocks, or “busts” and “bubbles”.
Capitalising on investing emotions
Every now and then extreme emotion causes a stock to be either cheap or expensive and this can lead to opportunity. This is how we like to think of the term “contrarian”.
The idea of simply buying a stock because it has fallen in price, or in valuation, is not in itself enough to qualify as contrarian. In fact, we strongly discourage investors from buying falling stocks or selling rising ones.
In most cases if you behave in a truly contrarian way and bet against the market it can be extremely dangerous. The idea of a swashbuckling investor buying all the dips and “fighting the market” is a scary one. The investment processes within our funds expressly prohibit us from buying falling stocks or selling rising ones.
Sometimes “group think” or “group emotions” can be so extreme as to create an opportunity where a stock becomes very cheap or very expensive.
In our version of contrarian, we wait for these extreme emotions to take their full effect on a stock price, sending it to either extremely low or extremely high levels. Then, when the stock has finished rising or falling (when the longer-term trend has ended), we commence either buying shares in an undervalued company or selling shares in an overvalued one.
One of the most important points about this process is the irony that it may not be that contrarian at all. It involves a lot of patience and waiting for a share price to finish falling or rising before either buying or selling.
Whenever I hear an investor say they “love” or “hate” a stock, my ears prick up. The words love and hate in relation to stocks is very emotional for what is, in the end, simply the process of buying and selling shares.
Hearing these words, I think if someone loves a stock they are being driven by strong emotions to buy and if they hate a stock they are being driven by strong emotions to sell it. If these investors are being driven by strong emotions to buy and sell shares, this may be causing stocks to become cheap or expensive.
The interplay of emotions causing stocks to become cheap or expensive leads to two very basic, but important rules:
No matter how cheap you may think a stock is, if investor emotion is sending a stock price down you do not buy it. This means you do not buy a stock that is falling in price.
Conversely, no matter how expensive you may think a stock is, if investor sentiment is sending the stock price higher, you do not sell a rising stock, nor do you short-sell one.
Many fortunes have been lost buying falling stocks and short-selling rising ones. This is not a form of contrarian investing we engage in and not a form we would recommend.
What is useful is to think about investment scenarios in a contrarian way. This can lead to opportunities.
For example, is a pizza company justified in trading on a Price Earnings multiple of 64 times? Is an electric car manufacturer worth $64 billion if it has never turned a profit and may never do so?
Are coal stocks only worth three times cashflow or will the world still need coal in the future? Is a fintech company that makes no profit and may never do so, worth $1 billion?
What happens to heavily indebted infrastructure companies when interest rates go up, and are they really a defensive investment under this scenario?
These contrarian thoughts and questions may be in contradiction to the actual share price movements of these companies. However, contrarian thinking could prove useful when the share price trend reverses and investors no longer love or hate a stock.
We believe that contrarian thinking about investment scenarios is an important component of the job description. What is not a part of the description though is buying shares that are falling in price or selling those that are rising in price.
Who are we to say how low a share price will fall or how high a price will go based on emotions?
Written on our office wall are the following two sentences: “Buy stocks that are going up. Sell stocks that are going down.”
The goal is to be contrarian by nature but never to “fight the market”. Nobody is bigger than the market.