Baring all: Making the bear case

We've all done it. We've become excited about a company, having done only the bare minimum of research. We've bought the stock, confident it's the bargain of the century. Then we've told ourselves it's set to double – nay, triple – once the market understands the story.

Instead events overtake the fantasy we've constructed in our minds. Bad news emerges and the share price slides. In fact the market did understand the company's story, but it was quite different from the one we imagined. The truth dawns: we didn't understand the company quite as well as we thought we did.

So what can you do about it?

Why not follow the same process that Intelligent Investor Share Advisor goes through with every new Buy recommendation? Instead of focusing exclusively on the 'bull' case for a stock, our analysts spend significant time examining the 'bear' case as well (mostly behind the scenes). Graham Witcomb's recent review Acrux: The bear case is a recent example where we've shone more light on the process.

For each and every stock there's both a positive and a negative case. It's why one market analyst can call a stock a 'Buy' while another says 'Sell'. It's also why you can usually find a seller when you're looking to buy (and vice versa). Many views make a market.

Making the bear case is particularly important for value investors. Many stocks value investors consider have something unpleasant about them, else they wouldn't be cheap. Understanding the source of this unpleasantness – and how long it might endure – is what underlies every buying opportunity.

So how might you make the bear case in practice? Whenever you're researching a new stock, ask yourself the following questions.

What are the market's expectations?

Knowing what the market expects can help you avoid buying duds. Take education provider Navitas, which recently announced that Macquarie University would take its student 'pathway programs' in-house from 2016, ending an 18-year relationship. The announcement surprised the market, with Navitas's share price falling 31% on 9 July.

Knowing what assumptions are embedded in the share price will help you determine whether the market is being too optimistic – or too pessimistic – about a company's future. Navitas's announcement showed the market had been paying too much for less-secure-than-expected earnings. OrotonGroup's loss of the Polo Ralph Lauren licence in 2012 is another example.

Why are others selling the stock?

When you're looking to buy a stock that's under pressure, put yourself in the seller's shoes. What are they thinking and why might they be worried?

With Acrux, we identified three main reasons why the market was now more negative than two years ago. These are mainly short-term fears that recent facts already suggest might be unfounded (see Acrux's sales impress from 25 Jul 14 (Hold – $1.28)).

Be aware that the prevailing mood will be negative when a stock is under pressure. Expect plenty of market 'noise', such as online forums critical of a company's products (as we've seen with Acrux). Learn to distinguish between important and less relevant information, with anecdotal reports usually falling into the latter category.

Why are these sellers wrong?

Knowing the reasons why others are selling is insufficient. Making the bear case – and then deciding to buy in spite of it – involves being able to articulate why selling is the wrong course of action.

Perhaps other investors are wrong because their timeframes are too short. For example, you expect poor industry conditions to return to normal within a few years.

Or perhaps they're wrong because the market is focused on something you consider less important. For example, the market might be worried about a company's total indebtedness while ignoring a debt structure that should permit it to survive.

Ideally you should consider what might change to help crystallise a company's underlying value. Perhaps new management might take a more active approach, or a takeover might emerge. But identifying a 'catalyst' isn't necessary – if the value in a company exists it should eventually reveal itself.

What don't I know?

It might seem a strange question, but what information are you missing? The information that's readily available for a company – such as ASX announcements – might not be adequate for you to assess the potential negatives. Remember that what the company releases is only one side of the equation.

Take time to read as widely as possible. External sources such as industry journals, analysis of the regulatory environment, broker research, and analysis of competitors can help you fill in the blanks. You can't know everything about a company, but you can limit what you don't know.

What different outcomes are possible?

The future is inherently unknowable. So it makes sense to prepare ourselves for different outcomes for our stocks.

It's why you'll often see us produce 'bear', 'base' and 'bull' cases for the stocks we recommend. Occasionally we'll provide a downloadable spreadsheet you can use to test your own assumptions (see ASX: Competition cuts infrom 28 Nov 12 (Long Term Buy – $29.33) or ResMed's dream run continues from 25 Jan 13 (Long Term Buy – $4.52)).

Think about the probabilities of different outcomes, which will help focus you on the likelihood of particular risks. And remember that one possible outcome is total loss of your capital.

What else could go wrong?

You can't foresee every possibility. But a company's situation sometimes keeps deteriorating and, despite your best intentions, the market proves to be right after all.

Be prepared to admit your thesis is broken if certain milestones aren't reached. That way you'll be psychologically able to act to preserve your remaining capital.

As important as it is to think about risks, making the bear case for a stock is much more than that. It's about fully understanding the opposite point of view.

There's a wrong investor on one side of every trade. By understanding and analysing your opposite number's reasons for selling, you greatly improve your chances of being the one that's right.