Learn to love bad news then buy big

Unless you train yourself to buy on bad news, your long term returns from the sharemarket are unlikely to be outstanding.

I'm currently reading Investing the Templeton Way, the latest book on John Templeton, by Lauren Templeton and Scott Phillips. The fawning account of his career and tedious writing are hard to take, though, so it's only for die-hard Templeton fans.

I've been a devotee of Templeton's investment style for a while. I particularly admire his flexibility and insightfulness and, most of all, his ability to buy stocks when others are petrified.

For example, the book relates how he bought several US airline stocks shortly after September 11, 2001 when even the airlines themselves said bankruptcy was imminent. A government bailout ensued, and Templeton banked profits of up to 70% in six months.

Templeton's approach illustrates the benefits of buying on bad news. Indeed, he sought more than just bad news; his aim was to buy during periods of 'maximum pessimism'. We'd all do well to take a leaf out of his book.

Few investors do. Most, myself included, tend to buy mildly underpriced stocks because periods of 'maximum pessimism' are fairly rare (and holding too much cash is often a mistake). But you reduce your chances of generating excellent long term returns by limiting your purchases to mildly underpriced stocks. I'll use the example of Sonic Healthcare to illustrate.

After taking a year to get comfortable with the company, I upgraded the stock to Long Term Buy at $14.62. It was a quality business, and less expensive than previously. In short, it was the classic, mildly underpriced, Long Term Buy.

If you only buy these types of stocks, though, your long term returns will be adequate but not outstanding. It's a mistake, in my view, to shoot all your bullets buying mildly underpriced stocks. Instead, you also need to wait for the bad news.

In Sonic's case, this occurred in May 2010 when the company reported a profit downgrade (although I still wouldn't call this one of Templeton's periods of 'maximum pessimism'). We then upgraded Sonic to Buy at $10.03. This opportunity only lasted a month, illustrating that you need to act quickly on bad news. We may get another chance if another profit downgrade ensues, or the government continues to tinker with industry funding. Both remain real risks.

My point is this. As value investors, we're often buying stocks that report bad news (this can be frustrating, which is why value investing is difficult). As that bad news tends to dribble out over time, you need to be able to take advantage of it.

This means buying over time—and particularly on bad news—rather than in one hit. You buy a smallish holding if a stock is mildly underpriced, buying more if the value improves. Obviously you need to maintain cash for this purpose.

Woolworths is a current example. It's an extremely high quality business, but I suggest you don't fire all of your bullets just yet. Coles appears to be in the ascendancy for now, while Woolworths' home improvement venture could disappoint. Woolworths is only mildly underpriced—as the Long Term Buy recommendation indicates—and there's some chance we'll get a better opportunity.

Bad news is the friend of the value investor. To finish, I'll leave you with the immortal words of Charlie Munger: 'It takes character to sit there with all that cash and do nothing. I didn't get to where I am by going after mediocre opportunities.'

How do you approach this issue? Do you try to wait for bad news before buying? If not, do you set portfolio limits when buying mildly underpriced stocks?

Disclosure: The author, James Greenhalgh, owns shares in Sonic Healthcare, as do other staff members.

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