Why the hell would you invest in a down market?— This is the question I heard from a security analyst in a thematic hedge fund.
He is not nobody, he is a friend from law school.
I have to admit I got a bit perplexed when I heard this. I couldn’t get it whether this was a real question or it was a manifestation of a belief in a different investing theory.
Because for me it’s intuitive— the best time to buy is when it’s down.
“No, you don’t understand,” he went on, “clients look at their capital accounts one day and they see they are now down 20% while it was only 10% yesterday. And you are putting new money in? You are fired.”
This is why Wall Street came up with all those platitudes:
“Don't be a hero in a falling market; never catch a falling knife; the trend is your friend.”
I thought about my own track record just after the conversation and I noticed that I made most of my killings in down markets.
I had never thought about how I was investing in down markets until then. It wasn’t random— there was a pattern.
When I reflected on it with hindsight, I noticed that it was ridiculously easy, and even better, it was nearly risk free.
I am going to share it with you today.
Why Invest In A Down Market?
I don’t think Warren Buffett has ever been accused of giving out shitty investment advice.
The best time to deploy capital is when things are going down. — Warren Buffett
He practices what he praises.
In the great market crash of 1979, Buffett invested heavily in ABC; post-1987 crash he bought Coca-Cola shares; bought Wells Fargo and Bank of America in the 2008 crash; bought Apple in the 2016 mini recession and after the 2022 crash etc…
The rationale behind investing in a down market is ridiculously simple. — It’s your best chance.
If you don’t invest and if it’s not a big disaster, it’ll recover and you will have missed your chance to make a killing; if it’s a once in a century disaster, holding onto great businesses is still your best chance to survive.
That’s not a platitude. Germany was devastated after World War II, yet Mercedes shareholders saw their wealth only grow in the next decades.
You can’t do it blindly though.
First you need to understand how the down markets unravel.
Anatomy Of A Down Market
Inversion is a very powerful mental model.— Let’s just stop and remember the old Charlie here, he was truly a great man.
Down markets are inverted versions of up markets, nothing more.
You are going to find many explanations as to how bubbles form. This is my own.
It happens as follows as far as I have observed:
People buy good business and they deliver.
When they deliver, it attracts more investors, they get overvalued.
Some investors understand they get overvalued and try to find other stocks.
Wall Street has a fancy name for this third phase— broadening.
In broadening, some money goes to unworthy companies, taking them to unreasonable highs.
And remember, money can pour way faster than companies can deliver.
So, at some point we have too much more money invested in good and promising companies than their performance can justify, and some money invested in unworthy companies on wrong premises.
When some bad news comes and people start to think their expectations won’t come true, money starts to flow out— boom, you have a down market.
It proceeds like a perfectly inverted version of an up market:
People sell speculative businesses first and strongest.
Second, promising businesses get smashed to undeserved lows.
Third, established, high-quality businesses shrug off the excess market cap.
In this madness, you only hear one word— “sell, sell, sell.”
Astute investors stand in calm, and give a playful smile.
“Fu*k off, I am buying.”
How Do I Buy In A Down Market?
You gotta wait.
This is the first rule.
Just as a market bubble doesn’t form until the rally broadens and money flows into unworthy companies, a down market isn’t confirmed until money draws from even the best business.
And this should be the goal— buying the best businesses at cheap prices.
These are Amazon’s, Meta’s, Costco’s, Google’s of the world.
When bought at attractive prices, there is a high chance that they will compound at +10% levels for decades. This is the base of your generational wealth.
In this waiting, you’ll see some exceptional growth stocks pulling back to what it seems like unreasonable lows. They’ll be down 30%, 40%, and even 50%…
“This is stupid, I am buying” people holding them will yell.
You will be tempted to buy. You missed the 3x return in the last two years, and now that it halved, you don’t want to miss the future rally.
I do get tempted too, everybody does but you gotta hold it…
Buying Meta at 12 times earnings is way safer than buying a hot growth company at 40 times earnings even if it was previously trading at 80 times earnings.
So, once the money starts to flow out from even the best business, I start looking to buy them.
How do I understand this? Their valuations get compressed, significantly.
There is a crucial point here.
Even if their valuations get compressed, not all of them are automatic buys. They should be undervalued.
I follow a very simple strategy here.
You gotta first verify nothing has changed in their fundamentals. You have to verify 1) the earnings growth in the last 5 years are consistent, 2) median return on capital hasn’t dropped below average (~12%).
Second, you gotta understand when they are undervalued.
If the return on capital hasn’t collapsed below average and you don’t see OBVIOUS disruptive threats to their business, all you need to do is simple:
Look at the average earnings growth over the past five years.
Assume a conservative earnings growth for the next 5 years.
Attach a conservative multiple.
If the average earnings growth in the last 5 years was 20% and the return on capital didn’t collapse, you may assume conservative 10%-15% growth for the next 5 years.
In 2021, META’s 5 year compounded EPS growth rate was 30% and full year EPS was $13.8
You could assume that growth would compound at 20% annually in the next 5 years.
For the end year 2024, you would get $23 EPS.
What would have been a conservative multiple for it?
Even if you attached the market multiple of 20, you would have gotten a $460 price target for 2024. Discounting it back to 2022 at 10% would have given you $345 fair value. Apply a 20% margin of safety, your entry price would have been $266.
The critical point is that you should have that valuation in your mind and when it gets there, you shouldn’t wait for the dip, you should start buying.
The stock was trading at $380 levels late 2021. It declined below $266 in early 2022.
I started buying around $240.
You can never know whether the market is gonna go up or down, you can only know whether a business is undervalued or overvalued. On my calculations, Meta was undervalued.— It would become grossly undervalued.
Market kept going down. This is why not going all in is important. If it keeps going down, you should be able to average down so all your next purchases should be big enough and low enough to allow that.
Meta went to $200, I bought a chunk. Then it went to $170, so I bought a chunk. It went to $130 and I bought a chunk bigger than all others.
In early 2023, it went to $90.
Meta was now my biggest position, my average purchase price was around $165. My money was nearly halved, my portfolio was only red, everything looked grim.
If I was running a portfolio in Wall Street, I would have been fired three times already.
I didn’t know it was a dip, I couldn’t buy it because I was out of investment cash. By the time I raised some cash and I bought it, it was around $95. It was a small purchase.
You know the rest…
By April 2024, it had recovered to $500. I exited there to look for other undervalued opportunities. I got back into Meta two months later when it pulled back 20%, but it was, still is, a small position.
I do this all over again. Rinse and repeat.
I think there are two important points here:
The first is obvious— the market can always go lower than you think.
You should never go all in, leave yourself room and money to average down.
The second is obvious on the data. Even if I didn’t average down and stuck with the initial position at $240, I would have still doubled my money in a year.
As I said earlier, you can never know where the market is heading, but you can know when something is undervalued.
When applied with patience, this is a nearly risk free model of making money.
Investing For Growth In Down Market
Here is a one sentence guideline for you to navigate market downturns— What drops last, recovers first; what drops first, recovers last.
This is intuitive.
People flee risk assets first and they get back on them last.
Small, fast growing companies such as Hims, Sofi, Hood are less predictable than those dominating tipped markets like Meta, Microsoft and Apple.
Thus, by the time the likes of Amazon recover, those like RobinHood are still very early in their recovery process so they tend to be cheap.
They start their rapid recovery only after investors think the forward return in established assets like Microsoft aren’t that favorable. Remember this from somewhere?—Yes, it's broadening.
This is not a platitude. Here is the data:
The market dipped around December 2022, and established companies had largely recovered by December 2023— Not smaller growth companies.
As you can see, by the time established winners recovered, strong growth stocks like RobinHood, Sofi and Coinbase were still at least 50% down from their highs.
You could buy them at a great discount even after recovery was confirmed.
This is where I like buying them— not into a down market but into an up market.
Your cost basis won’t be as low as it would have been in the depths of a market crash, but you will still have a limited downside and disproportionately large upside.
Buying the right names here positions your portfolio for outperformance in the next decade.
Repeat
As I explained, money leaves the risk assets first and safe havens last. This allows you to repeat this strategy many times until the market fully recovers.
In the end, had money barely left American-Express in 2022 crash.
It was around $190 in December 2021 and it was still at $170 levels in February 2023.
Because people see companies like American-Express as a safe haven, they draw their money from tech stocks in bad times and put it in the likes of American Express. Thus, the stock didn’t really crash.
Until late 2023…
You should ask— Why the hell on earth such a safe and strong company crashed when others were recovering?
The answer is in the question.
As people became hopeful in recovery, they started to draw their money off the stocks like American Express and put them back into the ones like Meta.
So American-Express dipped, it was trading at 14 times earnings. I made it my biggest position. It is still among the top 3 and I don’t think I’ll sell it in the next 5 years.
It’s up nearly 100% since my purchase.
What’s the risk in buying American-Express at 14 times earnings in an up cycle?
I am not a genius, after all I bought American-Express. It’s the strategy that works.
If you understand the dynamics going on here as I explained, you will see many opportunities like these in both down and up-cycles like Meta and American Express.
You just need to look. I promise you’ll see.
Position Sizing
As long as you see undervalued monopolistic businesses, like Amazon, Meta Microsoft etc.., you should buy them. I don’t even start thinking about owning others before all of them are fairly valued or overvalued.
You can divide the money equally, this is the simplest thing to do and so it works best for most people.
When they recover, become fairly valued, you start looking at high-quality growth names as I explained above. Majority of them will be very early in their recovery.
Among those, you only buy one group— The ones with growing revenue and positive earnings or clear pathways to positive earnings.
Don’t overpay. I wouldn’t pay more than 6 times sales.
Plus, those businesses combined shouldn’t be more than 30% of your portfolio.
What about those that don’t make money but offer great promises? How much of them should you buy?— None.
Investing in pre-money projects is venture capitalists’ sphere, not common stock investors’.
Final Thoughts
Will this work for you?— I have no idea to be honest.
It has worked very well for me so far and I know many people following this haven’t regretted. I think Buffett also follows a similar pattern.
Interestingly, the stock market isn’t a place where ideas win. It’s just like business. Execution wins.
There is no shortage of great ideas and strategies in the stock market, there is a shortage of great execution. Mediocre strategy executed perfectly tends to provide a better result than a poorly executed great strategy.
Courage, emotional control and a contrarian mind are must.
Even then, you can’t be sure of success, but odds will be on your side.
This is as good as it gets in investing.
I hope this is helpful.
See you in the next issue!
Selling higher strike future calls against your holdings when it is overbought is always a good hedge against inevitable down markets. However it's not always available to many retail traders due to the fear of options. And yes, you may lose your shares to profit 😜
On average AXP was never priced that high. The average PE was historically around 14-15, so no big discount as you bought it back in 2023.