Fundamentally Challenged or Fundamentally Cheap? Bargain Hunting in a Down Market
In downward trending markets as we have seen for much of 2022, it is important to distinguish price declines which may present similarly. Both index and active fundamental portfolios have moved, but not all securities move for the same reasons. Some investments move because fair value has declined; others move because they are getting “cheaper.” Because indices are designed to be measures of the current market, any market declines experienced in indexed portfolios are inherently a decline in fair value. However, it is the job of the fundamental investor to isolate those securities in which the underlying value is less volatile than security prices, buying as instruments get cheaper and selling as they reach or exceed fair value.
To this end, the job of the value investor is not just to find good companies but to find misunderstood companies. It is a sort of analysis arbitrage. The most attractive securities are those that are not just issued by strong companies but are also cheap. In an undulating market, a value discount can sometimes offset market movements and mitigate volatility. In a rising market, earnings can reveal the additional value to be found in an underpriced security. And when the market or economy is facing headwinds, that is the opportunity to separate the fundamentally challenged from the fundamentally cheap—to avoid the issuer which has experienced a fair value decline in favor of the issuer who has experienced merely a price decline.
When we look at the economic environment today, this distinction is particularly notable. The first half of 2022 has been a headwind to all credit portfolios, fundamental or not. And there is no way to sugarcoat why. The risk of a recession in the near- to medium-term future is not low. Wage gains have not yet caught up with recent inflation, and the impact is being felt all across the country. However, that consumers are so aggrieved about higher prices tells us less about the purported opportunism of the small business owner as it does about the visceral impact of higher prices on people’s fiscal confidence. In fact, there is no shortage of indicators to show just that (see Figure 1).