A simple analogy for successful investing: the coil spring

13 September 2017Paul Bosman, PSG Asset Management
Paul Bosman, a Fund Manager at PSG Asset Management.

Paul Bosman, a Fund Manager at PSG Asset Management.

The key to successful long-term investing is to think rationally rather than emotionally. When valuations are stretched – buoyed either by optimism or, as in recent years, the search for yield and the willingness to attain it at a price – it’s important to be cautious. When valuations are depressed – driven down by pessimism or fear – that’s the time to show interest.

Prices of securities (shares and bonds) are set at the levels on which buyers and sellers agree. Both parties are (generally) human, and as we know, humans are swayed by sentiment and emotion. Behavioural science has repeatedly shown that it is easy for almost anyone to get swept up in elation or halted by fear. Furthermore, many investors mistakenly extrapolate current conditions to inform their expectations for the future. It clearly follows that there is plenty of emotion or irrational thinking baked into market prices.

Investors should therefore look for securities that have more upside potential than downside potential. This is what we refer to as the coil spring principle. A stretched spring has plenty of potential for downward travel and very limited potential for upward travel. This illustrates the characteristics of an overpriced security, where the price has far more downside than upside potential. The converse is that a compressed spring has significant potential to bounce up and limited potential for further downward travel, illustrating the characteristics of an undervalued security.

Be cautious of broken springs

Of course, some springs have lost their bounce altogether. Investing in dud companies because you thought you saw an undervalued opportunity is a risk one runs when trying to find undervalued stocks to buy up. These are often referred to as value traps. To avoid broken springs, it is important to make sure you understand each company you invest in. What factors drive its profits? Who is the management team and what is their vision and plan? Why exactly does the security appear to be undervalued?

Where we are currently finding coil springs

Currently, there are real yields on offer from local fixed rate negotiable certificates of deposit. In addition, there is good value in selective offshore equities and local shares. Local government bonds are also currently trading at attractive real yields. However, finding undervalued securities in foreign bond markets or in the listed property universe remains more difficult.

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