Both cases raise an age-old question: should you buy stocks on bad news? Investment clichés such as "buy on the sound of cannons, sell on the sound of trumpets" - as a member of the Rothschild banking dynasty is supposed to have advised during the Napoleonic Wars - retain their resonance because the best buying opportunities do, in retrospect, turn out to coincide with periods of panic and pessimism.
As we all know, the problem is the difficulty of guessing, in the reality of prospect, when sentiment is at its lowest ebb. A prominent example of recent times is the banking crisis. Many experienced value investors (such as James Henderson, manager of the Lowland Investment Company (LWI) and Law Debenture Corporation (LWDB), two big investment trusts) and commentators (such as this magazine) underestimated the extent of the sector's problems when they first appeared with the failure of Northern Rock, and bought bank shares in 2008 because they looked extremely cheap by the usual yardsticks. On that occasion, however, it turned out the market was not, in fact, overreacting to intensive news coverage. Shares in Lloyds (LLOY) and RBS (RBS) are still below their levels even at the end of 2008.
Likewise, it is possible to imagine an escalation of the international crisis in Eastern Europe. If the US and European Union impose sanctions on Russia, Moscow will presumably retaliate. Will a company like Raven Russia (RUS), which owns distribution warehouses around Moscow, be allowed to repatriate the rental income that funds its high dividends? Similarly, exhibition company ITE (ITE), which makes nearly two thirds of its revenues in Russia, could struggle to attract international companies to its trade fairs.
Alternatively, of course, the situation could stabilise around a war of words and tokenistic diplomatic slights. That would leave shares in Raven Russia - down 13 per cent over a month and on a 7 per cent discount to historic book value - looking like a bargain. The same goes for ITE, whose shares are down by nearly a third over the month and now trade on 10 times current-year earnings, compared to a 10-year average multiple of 14. Both companies have strong long-term track records.
The difficulty of such an investment decision lies in the inherent opacity and volatility of an international diplomatic crisis involving competing political and economic interests. Some might argue you don’t have to believe that the rumpus over the Crimea will blow over any time soon in order to invest: value investors buy stocks not because they are prepared to make judgements about the outcomes of difficult situations, but because they believe a cheap rating already factors in the difficulty. But that's only reasonable if the problems do not deteriorate.
Buying on bad news may be easier in the case of profit warnings, which follow a more standard pattern. A 2004 academic study by Bulkley, Harris and Herrerias at the University of Exeter, based on 455 UK profit warnings between 1997 and 1999, found that stocks fell 17 per cent on the day of the update, relative to the market, and continued to underperform for about six months. About a year after the warning, however, there tended to be a strong recovery, with an average outperformance of 22 per cent over the following 12 months.
The behavioural explanation for this is that "we tend to hold onto our disappointments, and probably get round to selling them at just the wrong point," according to a crash-era research note by value guru James Montier, now at GMO. The drip-drip-drip of procrastinating sellers depresses the share price below fair value, eventually paving the way for a strong recovery. This offers a useful starting point for contrarian stock picking, if not with political crises at least with profit warnings. Don’t buy on bad news - but put a note in your diary to reappraise the investment case a year later.
