Recycle Friday! Featuring something we already wrote for someone else’s blog, but liked enough to eventually want back. Last spring this ran on Free From Broke. Today, we’ve updated it for a more mature audience.
Nah. Shop at the place next door, with the higher prices.
Why do people get excited when their favorite retailer holds a sale, but not when Wall Street does?
Let’s start with the obligatory disclaimer – this is not an encouragement nor a discouragement to buy or sell particular securities, stocks carry risk, consult a financial advisor but you don’t have to, etc. That was for that infinitesimally small segment of the population that is a) literate enough to read this post, yet b) dumb enough to do whatever a disembodied online voice suggests. There, now you can read the post absolved of any obligation to think.
Most investors know, in theory, that it’s foolish to buy at the top of the market and sell at the bottom. (Of course, human nature means that the opposite is true in practice – otherwise the top and bottom wouldn’t be where they are.) But it’s equally foolish to assume that the market will carry you along indefinitely if you just buy a flat representation of it and don’t research at all. We have 12+ years of real-world evidence of that. Factoring in inflation, the Dow has risen by an average of .4% annually since February of 1997. Your index fund would have been better off if it had collected tin cans since the Packers last won a Super Bowl.
There is such a thing as overdiversification. You might find stability in a comprehensive index fund, but it’s impossible to find any significant value. Buying a basket of Dow stocks, or something similar like a Wilshire 5000 index fund, will likely give fantastic returns over an 80-year period. If you plan on not waiting until you’re 115 years old to enjoy your money, there are more targeted ways to go about attempting to build wealth in the stock market.
Instead, look at companies that are temporarily wounded, i.e. whose stock sells at a discount. Earlier this year, when the global CEO of Toyota (NYSE: TM) was being grilled on Capitol Hill for selling cars to people who confused the brake with the accelerator, the company’s stock sank. But some fleeting bad PR can’t negate a decades-long reputation for value and quality. A few weeks after our demonstrative congressmen and senators finally pulled the curtain on their combination political theater/witch trial, Toyota stock had quietly gained 15%.
Around the time Toyota emerged from a bruising at the unfair hands of public opinion, British Petroleum (NYSE: BP) made Toyota’s problems look trivial. BP traded at $60.48 the day the Deepwater Horizon spill began. Today it’s at $36.52, a 60% drop. The rig’s manufacturer, Transocean (NYSE: RIG), has fallen from $92.03 to $50.04 over the same period, a 46% decline. Fortunately for Transocean, it’s in an industry with few players. Also, most people had barely heard of it since it doesn’t sell directly to the public. (When was the last time you bought an oil rig?) This distinguishes Transocean from BP, which plasters its logo everywhere and goes out of its way to embed itself in the public consciousness. Thanks to that insistence, almost everyone identifies the Gulf of Mexico spill with BP more than they do Transocean.
Both BP and Transocean have otherwise healthy financials that can normally withstand a one-time event. Then again, Deepwater Horizon is some event. But a wounded company isn’t a doomed company: despite the Exxon Valdez disaster, ExxonMobil went from pariah to the world’s most profitable company in just a few years. Johnson & Johnson rebounded after the Tylenol scare of 1982 and came back stronger than ever. There are several ways to murder a company along with its stock: obsolescence (Atari), poor economics (General Motors) and rampant crime (Enron) are three of the most efficient. But for a temporarily disabled company with a history of success and goodwill (in the general sense, not the accounting sense)? A resurgence is more likely than you think. Don’t confuse a broken bone with a bullet wound through the cranium.
One more time: there’s always value somewhere in the stock market, but very rarely can you make money simply by buying into the market as a whole. In fact, the times when the market (as a whole) rises fastest are when the gains are most dubious and tentative – case in point, the dot-com bubble and ensuing crash. More accurately, there’s always value in the stock market among particular entrants. Finding the ones whose stock prices have suffered for no better reason than that of public perception is as wise a place as any to start.
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BP are selling off assets and hemorrhaging key people. Transocean, OK. Toyota, sure. But BP’s case may really be a bullet through the frontal lobe.
This is a great tip. I would add that you might want to make sure the dust settles since the initial major drop can be followed by a dead-cat bounce only to resume a downward slide. The other piece of advice I would add comes from Jesse Livermore. Don’t put in your entire planned investment in your wounded stock, but a portion (say 20%) to verify that the rebound is truly occurring. Then add a little more once you have a solid profit in the initial purchase. If you are wrong with that initial probing purchase, be ready to sell and cut losses early.
Checking the headlines for info about the company is another good way you can find undervalued stocks. When it’s talked about, it will go up.
@101centavos:
Well, this week the New York Times reports that BP might be ripe for a hostile takeover from someone with deep pockets like ExxonMobil. As an investor, it’s hard to see how you could lose: either XOM bids above market price, or bids fair price and BP’s assets now go to work in the service of the world’s most profitable company.
@optionsdude:
Agreed. Couldn’t have said it better ourselves.
@Jason:
Uh, no. BP was talked about all last spring while its price was catering. If you were already a BP shareholder, you weren’t gleefully looking at the headlines every day. Over the last year, BP made its most abrupt gains when it was OUT of the headlines.