How to Buy Fear

Around the Curve

How to Buy Fear

While the stock market is pretty efficient, our favorite inefficiency is buying true fear. Fear versus rational analysis is not a fair fight, and this inefficiency never gets old.

Major equity indices around the world were down in the teens in the fourth quarter, with many stocks down 50% from their 52-week highs. That got our attention. When we see this type of correction, we ask ourselves:

  • Did the value of the business really fall 50%?
  • Is the stock going to zero?
  • Was the peak a proper level to anchor to or was that too high?
  • Is the current price level a bargain?

One of Wall Street’s favorite clichés is: don’t try to catch a falling knife. That has merit to it. After all, every stock that winds up at zero starts off by falling 50%. We know from experience that our first buy of a falling stock is very often not the low. We often expect the stock to go lower and size our initial buy accordingly.

But if you think about it for a minute, unless the stock is going to zero, it is going to bottom at some point. You only know that point in hindsight, when of course it looks obvious. Very often when a stock eventually reaches that bottom it is up again very quickly, and if you haven’t acted before that, you missed that gain.

The broad-based equity market rebound in January 2019 highlights this point well. So yes, we will buy stocks on the way down, especially in market environments like the one we experienced in late 2018.

How to Recognize Value

We certainly don’t automatically buy any stock that’s down 50%, but we look at them. Looking is free. We pass on the vast majority, but here’s what we generally look for:

  1. What does the balance sheet look like? We look at the balance sheet first, and that is usually where we stop. It usually takes less than two minutes. If you want to lose all your money with some regularity, buy stocks in free fall that have lots of debt. Those are the ones we pass on.
  2. Can we understand the business? There are businesses we are happy to leave for others who will understand them better than we do. There are plenty we can understand and we stick with those.
  3. Can we value the business within a range? We can’t value some businesses, but for the many we can, we do so through diligent financial analysis, and then we simply compare our appraisal to the stock price.
  4. Does this type of industry have a blind side? Industries that are clearly being disrupted also often turn out far worse than anybody expects.
  5. Do we believe we have a behavioral edge over another investor who is selling this security to us? We remain keenly aware of behavioral biases so we don’t fall victim to them.

Let’s explore number five more closely. For everything we buy, somebody is selling it to us. One of us is wrong. How can we raise the odds that it isn’t us?

We want to invest with people who are diligent and smart and motivated by intrinsic value analysis—but these are not the people we want to trade against. We much prefer to buy from an investor motivated by fear.

How to Find the Fear

Since the stock market is anonymous, how do we find the panicky seller motivated by fear? In a bear market, they are quite easy to identify. The panicked investor is very often the one willing to sell a stock that is down 50% in six months even though the business has a strong balance sheet. We rarely see this creature in a bull market, but saw it very frequently in the fourth quarter of 2018.

The stock market is a very competitive game and we are very clearly not the only investors out there trying to buy stocks for less than the underlying business is worth. Everybody has access to the same financial statements that we do.

Many investors wait for a stock to stabilize before buying—they don’t buy “falling knives.” When a stock is in free fall, a lot of potential buyers are likely to be sitting on the sidelines. This is a rare chance for us to be a buyer when competition is thin.

Fear: Our Favorite Market Inefficiency

So while the stock market is pretty efficient, our favorite inefficiency is buying true fear. Fear versus rational analysis is not a fair fight, and this inefficiency never gets old.



Important Information


All investments involve risk, including possible loss of principal.

The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested. 

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.

International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.

Past performance is no guarantee of future results.  Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not take into account the particular investment objectives, financial situation or needs of individual investors.

The information in this material is confidential and proprietary and may not be used other than by the intended user. Neither Legg Mason or its affiliates or any of their officer or employee of Legg Mason accepts any liability whatsoever for any loss arising from any use of this material or its contents. This material may not be reproduced, distributed or published without prior written permission from Legg Mason. Distribution of this material may be restricted in certain jurisdictions. Any persons coming into possession of this material should seek advice for details of, and observe such restrictions (if any).

This material may have been prepared by an advisor or entity affiliated with an entity mentioned below through common control and ownership by Legg Mason, Inc.  Unless otherwise noted the “$” (dollar sign) represents U.S. Dollars.

This material is approved for distribution in those countries and to those recipients listed below. Note: this material may not be available in all regions listed.

All investors and eligible counterparties in Europe, the UK, Switzerland:

In Europe (excluding UK and Switzerland), this financial promotion is issued by Legg Mason Investments (Ireland) Limited, registered office 6th Floor, Building Three, Number One Ballsbridge, 126 Pembroke Road, Ballsbridge, Dublin 4, D04 EP27. Registered in Ireland, Company No. 271887. Authorised and regulated by the Central Bank of Ireland.

All Qualified Investors in Switzerland:
In Switzerland, this financial promotion is issued by Legg Mason Investments (Switzerland) GmbH, authorised by the Swiss Financial Market Supervisory Authority FINMA.  Investors in Switzerland: The representative in Switzerland is FIRST INDEPENDENT FUND SERVICES LTD., Klausstrasse 33, 8008 Zurich, Switzerland and the paying agent in Switzerland is NPB Neue Privat Bank AG, Limmatquai 1, 8024 Zurich, Switzerland. Copies of the Articles of Association, the Prospectus, the Key Investor Information documents and the annual and semi-annual reports of the Company may be obtained free of charge from the representative in Switzerland.

All investors in the UK:
In the UK this financial promotion is issued by Legg Mason Investments (Europe) Limited, registered office 201 Bishopsgate, London EC2M 3AB. Registered in England and Wales, Company No. 1732037. Authorized and regulated by the Financial Conduct Authority. Client Services +44 (0)207 070 7444

All Investors in Hong Kong and Singapore:

This material is provided by Legg Mason Asset Management Hong Kong Limited in Hong Kong and Legg Mason Asset Management Singapore Pte. Limited (Registration Number (UEN): 200007942R) in Singapore.

This material has not been reviewed by any regulatory authority in Hong Kong or Singapore.

All Investors in the People’s Republic of China ("PRC"):

This material is provided by Legg Mason Asset Management Hong Kong Limited to intended recipients in the PRC.  The content of this document is only for Press or the PRC investors investing in the QDII Product offered by PRC’s commercial bank in accordance with the regulation of China Banking Regulatory Commission.  Investors should read the offering document prior to any subscription.  Please seek advice from PRC’s commercial banks and/or other professional advisors, if necessary. Please note that Legg Mason and its affiliates are the Managers of the offshore funds invested by QDII Products only.  Legg Mason and its affiliates are not authorized by any regulatory authority to conduct business or investment activities in China.

This material has not been reviewed by any regulatory authority in the PRC.

Distributors and existing investors in Korea and Distributors in Taiwan:

This material is provided by Legg Mason Asset Management Hong Kong Limited to eligible recipients in Korea and by Legg Mason Investments (Taiwan) Limited (Registration Number: (98) Jin Guan Tou Gu Xin Zi Di 001; Address: Suite E, 55F, Taipei 101 Tower, 7, Xin Yi Road, Section 5, Taipei 110, Taiwan, R.O.C.; Tel: (886) 2-8722 1666) in Taiwan. Legg Mason Investments (Taiwan) Limited operates and manages its business independently.

This material has not been reviewed by any regulatory authority in Korea or Taiwan.

All Investors in the Americas:

This material is provided by Legg Mason Investor Services LLC, a U.S. registered Broker-Dealer, which includes Legg Mason Americas International. Legg Mason Investor Services, LLC, Member FINRA/SIPC, and all entities mentioned are subsidiaries of Legg Mason, Inc.

All Investors in Australia:

This material is issued by Legg Mason Asset Management Australia Limited (ABN 76 004 835 839, AFSL 204827) (“Legg Mason”). The contents are proprietary and confidential and intended solely for the use of Legg Mason and the clients or prospective clients to whom it has been delivered. It is not to be reproduced or distributed to any other person except to the client’s professional advisers.

Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.

Active management does not ensure gains or protect against market declines.