“Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.” 
— Warren Buffett
Buy Low & Sell High, The Right Way
Let’s say you own a great business today and the price falls by 40% tomorrow. Should you buy more of it? All else being equal, you would be foolish not to buy more as long as your conviction in the intrinsic value of the business remains intact. Yet, the process of buying high-quality businesses at low prices is beset with behavioural challenges and something every investor must consider carefully.
Identifying Risks When Buying Stocks
Some of the key risks to stock investors tend to cluster around the following situations:
The other, which is likely to have relevance today, is when assets are still expensive. This may not fit the classic definition of a value trap, but an asset going from extremely expensive to moderately expensive is unlikely to make a good investment, even if the price has fallen meaningfully.
Lessons from a Classic Collapse
Some companies can appear strong on face value but tumble into structural decline. Take Kodak for example, where many investors in the 1990’s never anticipated the progression of digital cameras, nor that Kodak would be left behind in that progression. Buying in the dips would have been a terrible idea for most investors, as you would have continually bid up this exposure only to find it halve, halve and halve again.
Underpinning the above risks, a key challenge is that early and wrong can sometimes be indistinguishable in the initial stages of an investment. An investor who is early would likely prefer to increase their exposure as the probability of a turnaround increases (much like a poker player should). However, if that investment becomes wrong (a value trap), they should consider accepting their losses and moving on. It is entirely possible to be both early and wrong if the nature of the asset changes over time.
This is also a warning that cheap assets can get even cheaper, so it isn’t enough to simply buy cheap companies. We need to ensure the quality of their cashflows are sound and that they have durable advantages that allow for the benefits of compounding. For example, if a poor-quality investment falls by 20%, but could fall a further 30%, 40% or 50%, we likely want to avoid going all in.
In principle, if we want to buy high-quality businesses at prices below their intrinsic value, we must conform to the idea that we might be early to the party. After all, you are likely buying the investment today because it is unloved and no one else wants it (yet). By undertaking this exercise, there are no guarantees someone will want it next week, month or even year. Hence the reason value investors often cherish the word ‘patience’.
Our Process When Buying Stocks
Beyond rigorous research and risk management, we face an undeniable truth: buying high-quality stocks at a discount is not easy and we’re very unlikely to get the perfect timing on an investment. If we do, it will require a lot of luck. However, this doesn’t mean we should ignore the opportunity as valuation-driven investors.
To bring this to life, we consider the following as an important checklist. The idea behind this structure is to reduce the likelihood and magnitude of any mistakes, while giving ourselves the best chance of capturing value for our clients and delivering strong long-term returns:
A Buying Checklist
In summary, we like buying into weakness, but only when it makes sense to do so. To our way of thinking, the only way to know if it makes sense is to conduct rigorous checks before every buying decision (such as the checklist above). The key is to leave emotions like fear or greed aside, instead focusing on delivering long-term returns that can help investors achieve their goals.
 Source: Berkshire Hathaway 2008 Shareholder letter
We’ve taken your most pressing questions to our in-house investment professionals to answer them.
Question: Could the current low bond yields justify the high equity prices? Is there further room for even higher equity prices over the next 1 to 3 years?
Of course, they may be justified—and may even go higher—however we’d need to distinguish between cyclical and structural developments. That is, the long-run equity value discount rate really depends on whether borrowing costs will stay low permanently, due to some structural development, or likely to revert higher as conditions return to normal. This can be broadly captured in three scenarios.
1. In the ‘permanently low rates’ scenario, higher equity prices could be validated. Corporates will enjoy cheaper funding, default risk may remain lower than historical norms, and a transfer of wealth could see investors move from low-yielding bonds or cash into higher-yielding stocks.
2. In the ‘mean reversion’ scenario, the long-run relationship between unemployment and inflation will eventually stabilise, with rates nudging higher over time. As a result, profit margins will also likely normalise, sending equity multiples back to historical norms.
3. In the ‘inflation shock’ scenario, we may see the extraordinary levels of monetary stimulus create an unexpected rise in the cost of living. This would cause central banks to increase interest rates, likely suddenly, with both bonds and equities hurt at the same time.
While we must be open to the full range of possibilities, the probable outcome is that conditions eventually normalise. On this point, we think its dangerous behaviour to extrapolate recent trends into forecasts, so are generally sceptical of those predicting low rates forever. As Mark Twain supposedly said, “History doesn’t repeat itself, but it often rhymes.”
Question: Will diversification strategies continue to work given the unprecedented markets today?
At Morningstar Investment Management, we take diversification seriously. However, we’re generally quite sceptical of those who rely on historical correlation assumptions and prefer to instead look at it under the lens of fundamental diversification. That means we’re looking for an asset allocation that stands up to different risk drivers, not just co-movement.
As a simple example, it can be dangerous to buy equity in a company and then buy a bond from the same company, thinking you’ve got stock/bond diversification. The co-movement may look like diversification, but this won’t be helpful when it matters (if the company goes bust). The same can be said for asset classes, where an investor should think carefully about the underlying risk drivers of their asset choices. This has never been more important than it is today.
This question also highlights the important balance between conviction and overdiversification. Some of the greatest asset managers—whether equity-only or multi-asset—use concentration effectively. They balance out downside risks, to ensure the probability of permanent loss is small, but otherwise hold their highest conviction assets. At the other end, overdiversification can sometimes be a poor choice, as additional trading costs eat away at returns without any commensurate benefits.
Question: You’ve held high cash levels for some time. Why do you think it’s appropriate to hold elevated cash levels right now?
First, to establish a few facts. We think more cautious investors, or those with a limited investment timeframe, can benefit by holding healthy cash levels at present. For adventurous investors with a longer timeframe, the role of cash is still valid, but the sizing will often look quite different to those of a cautious investor (typically smaller).
Turning to our thesis, we are reminded of Warren Buffett’s quote, “holding cash is uncomfortable, but not as uncomfortable as doing something stupid”. It is counter-cyclical behaviour. To put a finer point on it—with bond market prices at record highs (yields at or near record lows) and equity market prices also near record highs, we believe it is prudent to protect capital. We think about this holistically, reducing the risk of a permanent loss by: a) favouring cheaper assets with less room to fall, b) offsetting risk via uncorrelated assets, c) using cash as a store of certainty, and d) monitoring the stewardship of all underlying investmentvehicles held.
But cash is also a form of offence, offering liquid ammunition that can be deployed as opportunities present themselves. Say, for example, that inflation unexpectedly jumps, causing central banks to raise rates quickly—a scenario in which stocks and bonds would likely fall together. Those that hold cash are in a position of power. This is just one scenario where cash would help an investor, but it will also work in several other scenarios that involve interest rate normalisation, a liquidity crisis, or a sudden market panic.
Importantly, we must disclaim that holding cash is not an effective long-term wealth strategy. It tends to earn less than inflation, which erodes your net worth. So, yes, we’ll use it to improve investor outcomes, but wouldn’t recommend it as a long-term wealth creation or preservation plan.
Question: Is gold something you consider in portfolios? When interest rates are negative, doesn’t this eradicate any disadvantages against cash or bonds?
We currently don’t invest in gold in our multi-asset portfolios, apart from the portfolios we offer in India. In general, gold doesn’t offer any cashflows to value (or compound), thus we’d expect gold not to generate a real return that is significantly above 0% in the long run. It is too often traded speculatively, where the future price is dependent on what the next buyer thinks it’s worth. To be clear, a zero percent real return might not be far off some fixed-income markets in terms of current yields, but it doesn’t make it an attractive investment (we also note there is not a carry premium associated with investing in gold).
To acknowledge the role it can play, gold does have some risk-hedging properties and may outperform in a risk-off environment. However, our research indicates that long-duration bonds (especially highly-rated government bonds from developed market nations) are generally a better hedge than gold in a risk-off environment. In general, gold is likely to do best in a stagflation or dollar crisis-type scenario, although these are low probability events.
Therefore, while gold can be debated as part of a risk management or portfolio construction exercise, it is highly unlikely we’d have long-run allocations to gold.