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Market slide: What would Buffett do?

Apparently it’s official. We’re in a stock market correction. Cue the clanging of cymbals and the dark, scary music.

Booms, busts, bull markets and bear – we love applying labels to the stock market. The financial community (mistakenly) thinks that makes the movements meaningful, and they’re easy labels for financial commentators to use. I’m not sure which analyst meeting or UN sub-committee made 10% the ‘official’ amount a market needs to fall to be labelled a correction, but I imagine they were also responsible for deciding soccer should be called football.

Back to the facts for a minute. Yes, the market fell over 10% between May 14 and yesterday morning, before recovering somewhat by yesterday’s close. Yes, the last month of declines have put paid to almost all of the gains made in 2013.

Now we’ve got that out of the way, we can turn to the question of what investors should do.

Heads I win, tails I blame you

Human nature is a funny thing, and never more so than when it comes to investing. When the markets are rising, very few investors ask themselves why it’s rising, just enjoying the ride as they get richer and hoping the end is nowhere in sight. They don’t question the forces behind those rises, at best ignoring them, and at worst believing the good fortune is down to their personal skill or ability.

But when the markets fall, investors get nervous, somehow oblivious to the reality that this is in large part – in the short-term at least – the other side of that same coin.

I’ve been saying for a long time now that <banks were overvalued>. I’ve also been warning readers to <avoid gold> and the <mining industry in general>.

In investing, the theory ‘what goes up must come down’ doesn’t necessarily hold – after all, the Australian stock market has increased 30-fold in the last three decades. But we can probably suggest that what goes up without a sound foundation is on shaky ground.

Valuation – as always – matters

Indeed, on May 10 this year, <I wrote>:

“According to S&P Capital IQ, the S&P/ASX 200 is trading on the highest level – as measured by the trailing price/earnings ratio – in over two years. So much so, that the average P/E has increased by around 50 per cent since this time last year!

“Remember, prices only increase for two reasons – either profits grow, or investors are prepared to pay more for each dollar of profit. I’m not suggesting we’re in any sort of bubble at the moment, but we’d be well advised to buy carefully from this point on.”

Some commentators would happily hold up such a statement as a sign that he or she possessed some special talent to foresee the market’s movements, given the recent high point on the ASX 200 was achieved only 4 days later, before the subsequent 10% fall.

I could easily make such a claim. But I won’t. It would be disingenuous. It might make me look smart, prescient and insightful – but the timing was just pure luck. Yes, I correctly (so far at least) saw overvaluation in banks and risks in gold miners, but that’s far from correctly calling some sort of market peak.

One commentator forecast a market fall in the US last night, which failed to materialise. In fact, the US markets were up more than 1%. I’m not here to criticise that call (although I do think trying to forecast short-term market moves is a waste of time) but to point out that if he was right, many of his readers would have hailed his success. That the fall didn’t eventuate will be forgotten by Monday. Such is the reality of punditry. Get one big call right and you can dine out on it for years, no matter how wrong you’d been before or after.

What is an investor to do?

The first thing is not to panic. The All Ordinaries fell over 10% between January 21 and March 10, 2003 – just over 10 years ago. The following 4 years saw a 150% gain in that index.

The 10% fall in January 2008 however, was to be just the start of the GFC-induced market falls that ended up wiping off around half off the market’s pre-GFC value.

What does a 10% fall tell us about the market’s next move? Precisely nothing.

The second thing is to go bargain hunting. An attractive investment idea one month ago is likely much more attractive now, when you have the opportunity to pay 90 cents on the dollar. Some companies are even cheaper than that.

Of course, just because the price has fallen doesn’t make a company cheap. If it was grossly overvalued before, a 10% fall probably just makes it very overvalued. As always, the price you pay and the quality of the company you buy matter. A lot.

Lastly, the investment spoils go to the contrarian investor. The one who took the opportunity to sell in 2007 when valuations were stretched, and had the courage to buy in 2008 and 2009 when many were claiming the financial world was about to end.

Warren Buffett – the best (and richest) investor in the world – attained those heights by internalising that very truth. As he says, “Be fearful when others are greedy, and greedy when others are fearful”.

Foolish takeaway

Buffett buys quality businesses when others misunderstand those businesses’ long term potential, leading them to be offered to him on the cheap. With all of the focus on short-term economic data and business performance, smart Australian investors have the same opportunity – especially with the market on sale.

If you’re in the market for high yielding ASX shares get “3 Stocks for the Great Dividend Boom” in our special FREE report. Click here now to find out the names, stock symbols, and full research for our three favourite income ideas, all completely free!

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Motley Fool Analyst Scott Phillips owns shares in Berkshire Hathaway.

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