There are bargains to be found in vicious markets

The other day, it was the turn of shareholders in Interserve (LSE: IRV) to experience a sickening drop in the value of their investment, as the company’s share price plunged 45% on news of a profit warning.
Over the summer, we saw similar sudden falls in the share prices of building firm Carillion (LSE: CLLN) and Provident Financial (LSE: PFG), as well as a number of more modest falls, as firms hit – or looked set to hit – choppy waters.
Even doughty and dependable brewer and pub chain Greene King (LSE: GNK) fell 15% in early September, after reporting that cash-strapped consumers were spending slightly less in its pubs and restaurants each week.

Risk and reward

To those who have yet to invest in the stock market, such price crashes are often seen as a sign of the dangers – or even folly – of investing in the stock market.
Better by far to put your money in the building society, they say – or even the Post Office. Savings accounts, they argue, might offer minuscule returns, but at least the value of your savings isn’t going to halve overnight.
Novice investors are a little more sanguine, of course. They understand the risks, but also understand that shares which have halved in value can also double. And – most importantly – that a well-diversified portfolio, spread across companies, geographies, industries and sectors, can minimise the dangers.

Opportunities lurk

Those with a little more experience may also see opportunity in such falls. Shares that have fallen sharply in price may represent a bargain, offering an attractive entry point at which to benefit from a recovery.
And that’s particularly true, of course, when the events that precipitate a given share price fall aren’t company-specific, but are instead a reflection of the travails of a particular industry or sector.
As I wrote several times last year, when events of that nature occur, I’m very inclined to take advantage of such low entry points myself – particularly when I see a chance to lock in an attractive income, as well as prospective capital gains.
For instance, I’m up 66% on Royal Dutch Shell (LSE: RDSB), 47% on engineering group IMI (LSE: IMI) and 132% on fellow engineer Weir Group – all purchased in January of last year, when oil firms and their suppliers were out of favour, due to low oil prices.

Stretched valuations

Even so, with all that said, there’s still another lesson to take away from the recent crop of sudden share price crashes.
Which is this: I think that they are a sign that valuations could be stretched, and that investors are demanding a high degree of certainty and predictability from the companies in which they invest.
And when they don’t get that certainty and predictability, they are prepared to mete out savage punishment.
As, of course, we are presently seeing.
So armed with that perspective, what are the lessons for investors?

Nervous markets over-correct

First, if investors feel that valuations are generally stretched, then the risks of a broader market correction are higher than usual.
Such corrections are painful in the short term but rewarding in the long term, offering a period of time when the market as a whole is priced at a more attractive entry point.
Corrections, though, are just that: corrections. And if the market as a whole fell 45% – as with Interserve, or Provident Financial – then believe me, that isn’t a correction.
When it happened in 2007-2009, for instance, we were using phrases such as ‘The Great Depression’ and ‘The Great Financial Crisis’.

Beaten-down bargains

But there’s a second, and potentially much more interesting lesson for investors.
We could well be in for a period when these abrupt share price crashes become much more prevalent. In this market, Interserve won’t be the last company to be savaged by investors following an unexpected profit warning.

Which isn’t particularly what happened in 2007-2009, of course – or at least, not outside the finance sector. In 2007-2008, the market as a whole sagged, although the financial sector led the way.
Here, we are seeing the FTSE 100 at near record highs, while investors maul individual shares – sometimes driving the share price down to levels that simply aren’t in tune with the underlying fundamentals or prospects of the business.
Put another way, for those with strong nerves, there will be definite bargains. But are you prepared to seize them?

Capital gains

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Malcolm owns shares in Royal Dutch Shell, IMI, and Weir Group. The Motley Fool have recommended shares in Royal Dutch Shell and Weir Group. 

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