It may not feel like a good time to be buying shares when the stock market has crashed. But sometimes such events can present investors with a once-in-a-lifetime opportunity to profit from a stock market recovery.
And well-known successful investors such as Warren Buffet often pursue strategies involving shopping for shares when the economic outlook is uncertain. That’s because uncertainty can lead to the stock market marking down valuations. And when that happens, shares sometimes under-value the intrinsic worth of the underlying business.
How I’d play the stock market recovery
Those successful investors know that buying cheap shares with a margin of safety can lead to out-sized returns in the years that follow. The stock market can be irrational. At times, it under-values businesses and sometimes it over-values them. Buffett and others tend to buy shares that are under-valuing businesses and sell them when they’ve made a good return, or when the stock market is over-valuing the underlying business.
But I wouldn’t buy just any old share that’s fallen a long way down in a stock market crash. I’d follow three simple steps to give myself the best chance of picking shares in strong businesses that have the best chance of recovering.
Step one is to look for businesses with an economic advantage in their trading markets. And I reckon the best way to identify the potential for strong business economics is to examine quality indicators. So, I’d look for companies that have a track record of producing decent returns on capital and equity.
I’d also look for high profit margins and a strong balance sheet. Indeed, low debts, or even a net cash pile, can point to a strong cash flow performance in a business.
And I’d want to see evidence of consistent and growing profitable trading. So, I’d look for a multi-year record of generally rising revenue, earnings cash flow and shareholder dividend payments.
If I can find all these quality indicators, there’s a fair chance I’m considering a business with strong economic advantage and moat-like defensive qualities that can fend off the competition. Further digging and consideration would likely prove or disprove the case.
Looking for quality at fair prices
Step two is to buy cheap shares that are undervaluing quality businesses. And Buffett once said he looks for wonderful (read ‘quality’) businesses selling at a fair price rather than mediocre businesses selling cheap. Indeed, it’s true we rarely find quality enterprises in the bargain bin. But in a stock market crash, they can fall from being over-valued to being fairly valued by the stock market.
And my third step towards making a million using this stock market recovery is to hold onto my cheap, quality shares for a long time. I want the economic landscape to improve and the growth potential of the businesses underlying my shares to manifest. It takes time, but the results could be worth it, say 10 or 20 years from now.