“Be Fearful When Others Are Greedy and Greedy When Others Are Fearful” – Warren Buffett
This is one Mr Buffett’s most timeless pieces of investment advice. It is based on a very simple observation. A financial asset is more likely to be undervalued when the majority of people are fearful about its future prospects, thus causing them to indiscriminately sell. In contrast, optimism and complacency about the future can lead people to be greedy, pushing up prices and leading to overvaluation.
Anyone who has practiced investing or studied financial market history in any detail will surely appreciate this. Many of the best investment opportunities have occurred at times of deep pessimism, despondency or disgust, whilst the big losses have often come after periods of seeming calm and happy prosperity.
But the past is the past. The problem with Mr Buffett’s observation is the difficulty of actually implementing it in practice, in real time, in the heat of battle. How can we know when others are being fearful or greedy? And, as importantly, how can we know if it is right to do the opposite? After all, being contrarian and wrong is not a good investment strategy.
In this post, I will outline the mental framework I use to help me determine the answers to these questions. The framework is inherently qualitative and subjective since we are, for the most part, dealing with human behavioural and psychological tendencies here.
There are five areas I look at.
Past price performance. Professor Robert Shiller in his seminal book Irrational Exuberance demonstrates the importance of the price-to-price feedback mechanism in creating bubbles and crashes1. Rising prices are often seen as a confirmation of underlying positive fundamentals, causing more people to become confident and buy, thereby increasing prices further. This positive feedback can sometimes work the other way too. Rising prices can themselves improve the fundamentals by, for example, increasing consumer confidence or making it easier for corporates to finance themselves. Of course these factors can easily play out in reverse when prices fall. Dramatic relative or absolute past price movements may therefore be a good starting point for assessing whether excessive greed or fear may be at play.
Valuation extremes. The next step is to assess valuation. This is important because valuation tells you something about market expectations. For example, if the valuation of a share is particularly low then this indicates that market participants do not expect the company’s earnings to grow much or in extreme cases to fall. This is a classic sign that fear may be at play. This is why I find it necessary to consider past price performance and valuation together. Substantial price underperformance most interests me when valuations are such that a very bad future outcome is already discounted into the price.
Shortening investment time horizons. The intrinsic value of any financial asset is usually defined as the sum of all the future cash flows it will generate, discounted back to the present. For the stock market, this means what happens over a short period of time such as one quarter or a year should not actually matter that much for overall valuation since the vast majority of value is determined by what happens in the outer years – the “terminal value”. In my experience, when greed and fear are at play, there is often a collective tendency to forget about this basic truism with the focus instead moving to short term factors. For example, in bear markets, incremental short term negative factors tend to get a huge amount of attention, much more than they would if they had happened in a bull market, whilst long-term value drivers are ignored or forgotten. If you see this happening, it may be a sign be that an irrational fear is driving prices.
News media and “new era” thinking. Shiller also shows how important the news media is in helping to form and perpetuate bubbles and crashes2. He argues this is particularly important when “new era” thinking is involved. “New era” thinking occurs when a new idea catches the imagination of the investment community. Such ideas usually take the form of some structural change that is interpreted as meaning profits will be permanently higher or lower going forward. As the bubble or crash develops, the incidence of news media stories citing the “new era” tends to increase dramatically, providing further support to the price-to-price feedback mechanism. To deal with new era thinking it is necessary to examine the assumptions underpinning the idea. Often the basic economic logic will turn out to be flawed, in which case contrarian behaviour may be warranted.
Unrealistic investment cases. Related to “new era” thinking will often come investment cases that are based on unrealistic long-term assumptions. In the depth of a bear market when fear is rampant, the assumptions used to justify lower and lower prices will become increasingly more negative. For example, a short term trend may be extrapolated out to the distant future, despite the fact that basic economics may indicate that such a scenario is highly unlikely to actually occur. It is easy to find oneself getting caught up in such thinking in the heat of the moment. When I look back at some of my own investment ideas in 2008-09 it amazes me how negatively biased my long-term assumptions were, even when I had a positive overall view. Of course at the time no one knew that the financial crisis would eventually resolve itself. But the fact that a positive fundamental outcome was often not even considered is certainly telling. I find in these situations it can help to distance oneself from the current turmoil by taking a longer term perspective, perhaps revisiting news stories or investment reports from previous years to remind oneself of what people were saying in “normal” times.
In next week’s post I will apply this framework to the oil and gas industry today.
1. This is covered in part one of Irrational Exuberance (3rd addition, 2014) by Robert Shiller
2. Ibid, see part two.