Successful investing is more than just identifying undervalued businesses. It is also about determining why the business is undervalued to begin with. Most of the time, you will find that it is due to either uncertainty or overreaction. And nine times out of ten, that uncertainty or overreaction will be based exclusively on short-term results.
Well-run businesses make long-term (multiple years) plans and execute on those plans with the end goal in mind. While they certainly track the progress of the plan along the way, one quarter of one year does not determine the success or failure of those long-term plans, as common sense would tell you. Yet analysts and the market in general focus intensely on quarterly results and seem to totally disregard the fact that each quarter is simply a part of the whole.
For instance, a business may make necessary and planned capital expenditures earlier than expected, thus hurting the results for that quarter while having no impact on the total cost of the long-term plans. Alternatively, a business may realize less revenue than expected during one quarter for a myriad of reasons, such as delayed marketing efforts, the delay of a release of a new product, severe weather that kept potential customers at home, or any other event that generally has no bearing on the future. Yet despite the fact that the long-term plans are still intact and being executed to the company’s satisfaction, the market will immediately sell and push down the stock price too far. This is clearly an overreaction, some of which is triggered by stop-losses put in place by some investors whereby they automatically sell if the stock crosses below a certain price.
On the other end of the spectrum, there are times when the market is fairly confident that the long-term plans will ultimately be successful but are uncertain about near-term results. It is equivalent to someone financing the building of a skyscraper telling the project manager, “I know the skyscraper will be built to the design and specifications within the desired time, but how far along will you be tomorrow?” When the market is uncertain about near-term results, the stock price is depressed until some more news comes out that gives the market some comfort.
Both of these situations (overreaction and uncertainty) present great opportunities to buy wonderful companies at depressed prices. One recent example of uncertainty comes to mind.
Collective Brands presented a great opportunity just a couple of weeks ago to profit from uncertainty. Collective Brands is better known by its primary chain of stores, Payless ShoeSource. Collective Brands is an extremely well-run company with one of the most competent management teams I have ever come across. Their management is their greatest strength, and that strength results in highly optimized operations throughout the organization. Analysts even agreed that the company’s long-term future looked pretty solid. But management refused to give any kind of short-term expectations, so analysts had nothing to go off of. As a result, the stock price was depressed. If you understood that long-term, the company would execute masterfully on their plans, then you would not care about quarterly results. And, since quarterly results do not matter to you, you would have bought at the depressed prices, and you would have had made money in a short-period of time. Collective Brands reported great results for the third quarter of 2010, thereby removing some of the uncertainty regarding the short-term. As a result, the stock price increased roughly 15% in one day.
This is just one example of many potential opportunities afforded by the market’s focus on short-term results when you know, based on your research and experience, that the long-term prospects of the company are bright. Uncertainty and overreaction are a long-term investors best friend. Without it, great companies would rarely be available at a substantial discount relative to its value. So take advantage of them when you see them and always remember the old adage by the great Warren Buffett, “Be greedy when others are fearful.”
Jonathan Booth, CEO