Profit from Bad News
Speculation fuels the stock market which drives stock prices higher. The momentum created continues to drive prices higher as more and more speculators buy the stock. These speculators build up their open profits as the stock price continues to climb.
Then some event occurs which shakes the confidence of these speculators and they sell their stock. This increases the supply of stock for sale which in turn drives down the stock price. The trend has now changed direction and heads downwards.
It's this short-term view that drives stock prices down with speculators buying on good news and selling on bad news, regardless of the company's long-term prospects.
This is the classic herd mentality that is driven by the financial media which fuels the short-term price swings but has nothing to do with the long-term business prospects of the company.
The Contrarian Investor
The Contrarian investor invests in what other investors find unattractive. These are stocks that have recently performed poorly and have fallen out of favor with investors. This ensures that the stock price is relatively low. But a low stock price is not in itself reason enough to invest in a company.
The company also needs to be financially secure over the long-term as well as have some form of competitive advantage which will help ensure the company's long-term survival. Companies with businesses dealing with consumer products and/or services that have a semi monopoly with their brand names tend to have an advantage.
These companies have products or services that people need and will continue to buy into the future irrespective of what the stock price does in the future. It's this future demand for the company's products or services that help drive future profits and therefore its future stock price.
The Stock Price
Stock prices are quite sensitive to news events. A good earnings report can see the stock price move up. A bad earnings report can see the stock price move down. Investors don't care if all indications are that the earnings will improve over the next year or two. Investors are only concerned about what is happening now.
Investors typically have a short-term view. If news about a stock looks good now then they will buy the stock, but over the next weeks or months these investors will sell if the news then looks bad. This is irrespective of the company's future business prospects.
This is one reason why mutual funds have high turnover rates. They buy and sell based on news events in an attempt to outperform other mutual funds on order to earn the Top Fund of the Year title. This buying and selling - while increasing market liquidity - also increases market volatility. At first this may seem like a bad thing, but it can lead to a buying opportunity for the contrarian investor.
The bad news phenomenon happens virtually every day to one stock or another. Simply read any of the internet market reports or watch the business report on television and you'll see that after any negative news on a company is announced, the price of its stock drops. If the news is really bad and the news is realized when the stock market is closed, the stock price typically gaps down significantly when the market opens in the morning.
The irony is that most investors buy the stock with the view to being stock investors over the long haul but their short-term actions lead them to speculation. Now there is nothing wrong with speculation - it's just that most investors insist that they are investors while their actions dictate that they are speculators!
The famous investor Benjamin Graham had a novel view on the action of stock prices - which he referred to as Mr. Market.
On some days Mr. Market was wildly enthusiastic about the immediate future of a stock and would ask for a high selling price. On doom-and-gloom days, when he was overly pessimistic about the immediate future of the stock, he quoted you a low selling price.
If the Contrarian investor thinks that the long-term prospects for the business are good and would like to buy some stock, then when should they take Mr. Market up on his offer? Should it be when he is wildly enthusiastic and quoting a high price? Or should it be when Mr. Market feels pessimistic and quotes a low price? Obviously when the low price is quoted!
Contrarian investors are only interested in the price that Mr. Market is quoting, they are not interested in Mr. Market's thoughts on what the company's business is worth.
A lot of investors are under the belief that Mr. Market accurately prices the stock and this is what the stock is worth. In other words, the stock price at any given point in time is the stock's valuation at the point in time. Now this works for private businesses and would be true for public companies except for one very important difference.
The only people who buy private businesses are people looking to buy a business, whereas with public companies it's mostly speculative buyers who have absolutely no interest in the companies business and their only concern is that the stock price continues higher. If the stock price falls - they sell.
To sum up - the difference is public companies are bought by people who have no interest in the companies business; whereas private businesses are bought by people who want to run a business.
Now since public companies are bought by people who have no interest in the business then how can the markets stock price reflect what the business is worth!
Keep in mind that the stock price is the price per share - there are only ever a fraction of the company's shares sold at any one time - its not the entire company sold in one go like it is with a private business.
Buying in Bear Markets
There are certain repetitive types of market, industry, and business conditions that produce the best pricing for stocks.
The simplest event for investors to spot is a Bear Market which essentially affects the entire stock market. While Bear markets are relatively rare they do regularly appear over the decades.
Graph 1. below shows how bear markets follow bull markets which in turn leads to the next bull market and the cycle repeats over again.
Graph 1. Stock Market Cycles
Most investors absolutely hate Bear markets due to the fact that their portfolio value drops, but Bear markets are a natural part of the stock Market cycle.
In contrast to most investors, Contrarian investors love Bear markets - firstly they acknowledge that Bear markets occur from time to time so it's no surprise when the next one comes along, and secondly they know that they can buy great stocks with strong businesses at ridiculously low prices during a Bear market, and thirdly they know that Bear markets are short lived and stock prices quickly recover when the next bull market gets going.
So when it's all over the Contrarian investor ends up with a stack of great stocks bought at bargain basement prices.
Other Buying Opportunities
While bear markets are great for buying fantastic stocks at ridiculously low prices, there are some other events that occur which can cause a stock's price to fall so that Contrarian investors can pick up a bargain. These include industry recessions, individual calamities, changes in corporate structure, and war.
INDUSTRY RECESSIONS: An entire industry suffers a financial setback. This usually affects all companies operating in that industry. Companies that only conduct business in that industry are really hit hard with massive falls in profits. Companies that also operate in other unrelated industries are less affected. The effect is only minimal if the company only derives a small portion of its earnings from the affected industry. Usually the financially strong companies survive the industry recession while the financially struggling companies are at risk of bankruptcy.
INDIVIDUAL CALAMITY: Sometimes management of brilliant companies do stupid things. This is a part of corporate life. A company with a competitive advantage will likely find its profits affected when management does something stupid, but if profits have plunged (thus providing a potential buying opportunity) then they are more likely to recover quickly. A company that has the financial power of a competitive advantage behind it has the strength to survive almost any calamity.
STRUCTURAL CHANGES: These can produce special charges against earnings that have a negative impact on stock price. Mergers, restructuring, and reorganizing costs can have a negative impact on net earnings. These are short-lived and can provide the Contrarian investor with a buying opportunity.
WAR: The threat of war can send stock prices downward regardless of the time of year. This will affect most of the market with the only possible exception being companies that provide military equipment. The uncertainty and great potential for disaster will affect most stocks. The sell-off is motivated by outright fear, which results in investors selling stocks. Sooner or later the conflict is over and the low prices lead to buying opportunities.
Stock Analysis for Finance Students and Investors