The holy grail of investing: An objective analysis of the worst case

I have read scores of books on investing and have been investing seriously for past 12 years. There are many concepts which I find extremely useful when it comes to investing: buy below intrinsic value, focus on quality, focus on what you can analyze, ignoring the market except when it gives you a good price to buy, hold as long as the business & management remains good, stay away from overcrowded areas etc. But if somebody asks me, what in my opinion is the biggest factors that makes or breaks an investing track record it is this: an ability to analyze the worst case.

In most cases my investments only perform slightly above the market average, though with a much lower 'risk' compared to the market. But the thing that still makes my investing record satisfying is the basket of stocks that I buy when the stock market is at its worst. Even then in retrospect I mostly find out I should have bought more!

If we look around most people try not to buy the stocks in such lucrative periods. One of the obvious reasons for this behaviour is herd mentality. If everybody else is doing one thing our subconscious brain triggers us to ape their behavior. But I consider myself a fairly independent thinker and choices made by others, though certainly had some effect, did not have significant effect on most of my decision making in the past. But even then I have ended up buying less that what should have.

I believe there is a second important reason for this sub-optimal behavior. The reason is having a subjective sense of the worst case. Most of the time when market is at a low, the conditions are truly uncertain. For example, I do not think there was any guarantee in October 2008 that we will not have another Great Depression. That it was the start of one of the biggest rallies was just one of the scenarios that unfolded, and it was tough to say if it was the dominant scenario if you watched the events unfold in October 2008. We treat these uncertainties with one simple conservative dictum "Stay away, anything can happen". I also do not subscribe to the other philosophy that we should go all in with our eyes closed because each time in past several decades such opportunities have led to supernormal profits. Just because it has not happened in past few decades, doesn't mean it will never happen (and stock valuations have gone lower than what people believe it could for a sustained period of time in the past).

Thought it is certainly true it is difficult to see what is going to happen in the future, in the statement: "Stay away, anything can happen", I find the word anything to be result of a mix of laziness and fear. It is what I call a subjective evaluation of the worst case. If you have not put your brain to it, any price the market offers will seem too risky for you.

In most crisis just about anything cannot happen. No matter how bad the past crisis have been, it was inconceivable that the civilized world is going to end, the global trade is going to stop (for more than a few months), that we are going to stop consuming most of the products that we know today. So no matter how severe the crisis seems to be, there is a bedrock below which the sinkhole cannot go. The trick is to try to find that bedrock of value of a company and go all-in if you find even a few cases where the price that market is asking for is lower than that value. Even if somebody forgets all other principles of investing, I believe just doing this one thing well will lead to superior results.

In my opinion, there are several methods to find this bedrock of value. For example, in many cases a stable part of business is protected from issues in other parts of the business. In case of products with good customer stickiness, low ticket size, a certain need and a good competitive advantage, it is inconceivable that the long term volume can go much lower. In some cases a bad economic environment can add to the strength of a company since competitors are going to suffer even more. In many cases lower volumes and price realization are offset by even lower raw material prices.The past volatility in volumes & profits during economic crisis can build more confidence into such judgement.

At the same time, there are companies where literally anything can happen. These are companies with high debt, companies in commodity business and companies who lack the strengths of their competitors. Going into the details of the drivers of the profit and trying to see what worst can happen to those drivers has another effect also. It helps overcome the subconscious fear & herd mentality as well. Fear & herd mentality comes from lack of knowledge. Once you really know something and you are also aware how you can trust your knowledge, fear & herd mentality tend to disappear.