Nothing can move a stock like a change in expectations, particularly when high expectations don't pan out.
It can happen slowly, like hot lava destroying everything in its path. Or it can happen quickly, like a thunderstorm popping up in the Midwest. Either way, value investors try to stay away from high expectations. That's because buying into them often leads to low returns or even a permanent loss of capital.
It's been a rough year for homebuilder Toll Brothers
It's tough to pass up buying stocks with rising prices. No one likes to be left out. But we have to figure out how to buy great companies at low prices, not high ones.
Recently, isolated storms have popped up and taken their toll on these companies. Career Education
In these situations, storms seemed to come out of nowhere to wreak their havoc. Does it mean these companies have suddenly turned bad? No. Falling prices usually mean expectations were too high.
Those three words
Nature is amazing. Time and time again, after disaster strikes, opportunity arises. When storms knock down older trees, light is exposed to the ground, allowing new plants and trees to grow, which provide food for bugs, which attract animals, etc., etc.
The same can happen in the stock market. After a fall, stocks can become bargain opportunities, but only under the right conditions. How did companies like Williams Companies, Procter & Gamble, Capital One, and Amazon.com, to name a few, become great investments after getting caught in a storm? It's not just because they're great companies. It's also because investors recognized three little words: margin of safety.
At our Inside Value investing service, we demand a margin of safety from every investment recommendation we make. That means we insist on price being lower than our estimate of a company's value.
We do this for two reasons. First, if our estimate of value is off, then we usually have some protection on the downside, as stocks with low prices relative to value tend not to fall very far. Don't get me wrong; stocks can always go even lower. But it's nice to have a shelter within running distance if we're caught out in a storm.
The second reason has to with the upside: The larger the margin of safety, the higher the returns as price and value converge.
That's the great thing about margin of safety. We protect ourselves from catastrophic losses while increasing the odds of beating the market. What more could investors want!
The Foolish bottom line
It's never too early to protect yourself from stock market disasters. That why Philip Durell, lead analyst at Inside Value, only recommends companies with significant margins of safety. He's disciplined and is not going to pay too much for a stock.
So to start reaping the benefits of margin of safety, click here to sign up for a free trial of Inside Value. Not only will you get to see where Philip is finding opportunities today, but you'll see what it's like to avoid storms and generate great returns.
David Meier is a member of the Motley Fool Inside Value team and does not own shares in any of the companies mentioned. Amazon.com is a Stock Advisor recommendation. The Motley Fool has a disclosure policy.