The FTSE 100 index is down from the peak above 7,100 it achieved in October. As I write, London’s lead index stands at 6,815, but it dipped lower than that over the last few days. Should investors worry about the regular setbacks we see on the stock market?
Lower share prices can be a gift.
I’ve noticed several headlines recently about companies with plunging share prices. The FTSE 100 index is made up of the aggregate share prices of its constituent firms, which means if the index is down so are some of the shares within it.
Share prices tend to fall when a firm reports news that isn’t so good, such as missing its profit forecasts. But shares can also fall for no reason in particular, perhaps just to blow some speculative froth off the price.
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Share price falls can be good news for investors because we have an opportunity to buy part ownership of the underlying business for a cheaper price. In other words, we have the potential to find better value than when the share price was higher.
Not all price falls reveal better value
Sometimes shares deserve to fall because of a change in circumstances for the underlying business or its potential. Price itself doesn’t dictate value. It’s possible for shares to fall a long way and still represent poorer value than when the shares were higher. A strategy of buying shares just because they’ve gone down will be unlikely to succeed.
In order to find good value among fallen shares, it’s necessary to focus on what makes up good value. To me, that means considering the quality of the underlying operation and its prospects. That’s a process that involves investors engaging in some thinking and judgment. I don’t think we can reduce analyses down to numbers alone. Although financial indicators can certainly point us in the right direction.
A good quality enterprise will likely show a decent profit margin, good inflows of cash, a generous return on invested capital and borrowings under control. Start with those figures and you might be looking at better value if the share price has fallen.
However, great investors such as Warren Buffett didn’t become great because they’re good at reading numbers alone. There’s a certain amount art to the game of investing as well as a dollop of science. Successful investors tend to think hard about a firm’s business and its prospects before taking the plunge.
Investing versus speculating
I reckon investing and speculating are different things. I’m fond of these definitions:
- Speculation involves timing the movement of money.
- Investing involves converting time into money.
If we take a long-term approach to buying and holding shares in firms with good quality underlying businesses and then think of ourselves as part owners in the enterprise, we have a much better chance of converting market setbacks and weak share prices into good long-term investments.
With such a mindset, weakness in the FTSE 100 and the wider stock market really could end up being good news for well-prepared investors.
