How to find cheap stocks to buy – 3 crucial learnings from superinvestor Mohnish Pabrai

What do you do when stock market prices are collapsing and everyone seems to be afraid? The news is negative, and some stocks are posting big losses. At these times, fear rules, but it can be a great time to find cheap stocks to buy.

Learning from superinvestor Mohnish Pabrai

In his excellent book, ‘The Dhandho Investor,’ he writes,

The Dhandho Investor by Mohnish Pabrai

“Fear and greed are very much fundamental to the human psyche. As long as humans drive buying and selling decisions in equity markets, pricing will be affected by these fear and greed attributes. When extreme fear sets in, there is likely to be irrational behavior.

In that situation, the stock market resembles a theater that is filled to capacity. Someone sees some smoke and yells “Fire, Fire!” There is a mad rush for the exits. In the theater called the stock market, you can only exit if someone else buys your seat—each share has to be held by someone! If there is a mass rush to leave the burning theater, what price do you think these seats would go for?

The trick is to only buy seats in those theaters where there is a mass exodus and you know that there is no real fire, or it’s already well on its way to being put out. Read voraciously and wait patiently, and from time to time these amazing bets will present themselves.” – Mohnish Pabrai.

Three things we can learn from Mohnish Pabrai about how to find cheap stocks to buy.

1.       The market will reach points of extreme greed (when prices are too high), and extreme fear (when prices are too low). This is because it is emotionally driven. When fear rules, when everyone is despairing, running for the exit and selling, there are daily news reports of big losses in stocks, and people are taking large losses, it might be time to buy. You need to expect these times, and watch other investors and the news to look out for fear-driven panics – where opportunity awaits.

2.       “You can only exit if someone buys your seat.” Every stock that is sold, must be bought by someone else. When fear rules, sellers will accept any price just to get out of the smoke-filled theater of the stock market.. The price will plummet, to what the few remaining buyers are willing to pay. 

     A real recent example is the Covid crash of March 2020: mutual funds had to sell stocks to raise cash to refund fearful investors running for the exits, and pulling their money out of the funds: many companies fell to 10 year or 20 year lows: only to recover sharply in a month to higher levels than before the crash, as fear receded. In this crash, I bought profitable companies at prices lower than their net cash! (net-nets). These later recovered to give strong gains.

When markets fall significantly, this is a potential opportunity to find cheap stocks to buy – but only a potential one because the price may still be too high vs the intrinsic value of the business. The third piece of advice is critical here – this tells us what to do when we are waiting for the next fear-driven opportunity:

3.       “Read voraciously…” you must prepare yourself by understanding the businesses behind the stocks, so that you can value them accurately, and know whether fear has driven the price to a level below the true value of the business, or if, even after falling, it is still overvalued. 

     For example, during the dotcom bust in the early 2000s, some stocks fell 50%, but then continued to fall until they were down 99% from their highs: and never recovered. This was because they had never made a profit and so the intrinsic business value was not there. 

     However, other businesses that were profitable were caught up in the panic selling, and fell to oversold levels. Investors that found these cheap stocks to buy, reaped handsome rewards as overblown fears receded.

In summary: to find cheap stocks to buy, we need to:

a)   Realise the stock market is made up of people, who sometimes reach extremes of fear

b)      In these times, quality stocks can be oversold as there is indiscriminate selling

c)       The investor who has prepared ahead of time, by learning which business are good quality and how to value them, can find the bargains (priced below true value) to buy, and the falling knives (still priced above true value) to avoid.

Helping you to buy cheap stocks: My mission at Real Worth Stocks is to teach investors how to accurately value stocks – to find their real worth: because we can see that the market price sometimes diverges from their true value, which gives buying opportunities. To help you take advantage of these opportunities, I write a free monthly newsletter with investing advice and stock write ups, so you can learn how to value stocks. Join now, and to welcome you, I will also give you a special bonus free download of my newsletter for paid subscribers, including our January-23 stock pick with detailed research report and valuation.

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