Don't make this $8 billion mistake

Why pay more for stocks that are selling cheap?

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"The future is never clear; you pay a very high price in the stock market for a cheery consensus"

Warren Buffett famously offers that warning for investors who may otherwise end up buying at the top of the market.

Only the most pessimistic of investors would suggest we're at a high point in the current cycle, and the last week is all the evidence we need that even the so-called 'smart money' doesn't know which way to jump.

The Australian and US stock indices are bouncing around. While the US debt problem has been postponed, consumers in the West continue to hold tightly onto the purse strings, and Europe still has a looming debt problem of its own. As a result, both consumers and companies are hibernating – refusing to spend, hoarding cash and paying down debt.

Reaping what we've sown

We shouldn't be surprised by the latter – we've been living beyond our collective means for years, and in the end you always have to pay the piper. We – consumers, companies and governments – collectively ran up unsustainable levels of borrowings. The only way to pay down debt is to spend less than you earn for a while.

The inverse of Buffett's quote is equally true – buying shares when the mood is pessimistic can be a very lonely pursuit. News reports frequently feature scary-looking share market graphs, your portfolio only ever seems to lose value, and even company results are muted at best.

Shutting the gate after the horse has bolted

It's hard to blame someone who wants to sell their investments and stick the money under the mattress until better days arrive.

The problem is that this tendency may create exactly the wrong types of outcomes for investors. By the time the share price has reached new highs, you've probably missed out on most of the gains. By the time the price has dropped 5, 10 or 20%, most of the money has likely already been lost.

An investor who can't resist the crowd is likely to be buying high and selling low – the opposite of what they should be doing.

The $8 billion mistake

Of course, not every drop is temporary and not every new high guarantees a fall. The former is often referred to as 'catching a falling knife', with the implication that you're safer waiting until the fall is over before trying to 'pick up' either the knife or the stock. Equally, the latter is typified by one of Warren Buffett's self-proclaimed 'sins of omission'.

Seeing the price of Wal-Mart rising, Buffett decided to wait until it had fallen before buying the shares. It never did fall back below his target price, and Buffett suggests that decision may have cost his company, Berkshire Hathaway, more than US$8 billion.

That said, success often comes from recognising episodes of market pessimism, and taking advantage of that mood by buying quality companies when they're cheap (or at least cheaper than usual).

Make Volatility Your Friend

In December 2007, Flight Centre (ASX: FLT) shares were trading at over $30. Then, only 14 months later, they traded for under $4 as investors fretted about the competitive threat from the Internet, consumers not travelling, and in the teeth of the GFC.

Fast forward just over a year, and by April 2010, the shares traded for over $20. The ride was hair-raising, but investors who recognised the inherent strength of the business and unreasonably low share price profited handsomely.

A quick look at the share prices of some of Australia's biggest businesses suggests the market may potentially be unreasonably pessimistic.

BHP Billiton (ASX: BHP) is trading at about the same price as one year ago, and almost 20% below the price 4 months ago. Woodside (ASX: WPL) is down around 25% from its recent highs.

We know about the retail challenges – and the market has responding by slicing almost 50% from Harvey Norman's (ASX: HVN) 12-month high, and not much less from the David Jones (ASX: DJS) share price. Even JB Hi-Fi (ASX: JBH), once a market darling, has lost a third from its own 12-month high point.

Foolish take-away

Every market low in history has eventually been bettered by a new high. More often than not, that recovery comes more quickly than investors expect, and by the time money is recommitted to shares, much of the gain on offer has passed. Prices may well have further to fall, but many quality businesses will emerge to set new share price highs from this downturn.

Investors may do well by seeking out the gems amongst the rubble. Later this week, we'll unveil a few stocks we think may well be worth a closer look.

Scott Phillips owns shares in Wal-Mart, Berkshire Hathaway, Harvey Norman and David Jones (but not Flight Centre, unfortunately!). The Motley Fool has a disclosure policy.

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