Why We Should Be Flexible in the Stock Market

When it comes to investing, most investors abide by a fixed set of rules that they follow religiously. For instance, they may not invest in companies that are making losses currently or companies with a price-to-earnings multiple above a certain level.

This was the mindset that framed the way I used to invest in stocks. However, in recent years, I have realised that this way of thinking may have hindered my overall stock market returns by making me miss out on great investment opportunities that I refused to touch because of my prior investment framework.

I am not saying that we should start investing in companies that we do not understand. I am simply saying that we should not rule out an investment opportunity just because it does not fit one of our investment criteria.

As such, I thought I would outline some reasons to invest in companies that had not fit my prior investment criterion, such as investing in unprofitable companies, and companies that trade with a higher valuation than I was comfortable with.

Why buy unprofitable companies?

I used to be one of those investors who would avoid unprofitable companies like a plague. This was partly due to the first book that I read on investing, which advocated buying companies that were able to generate high returns on equity and had stable profit margins. An unprofitable company obviously could fulfil neither of those qualities.

However, as I continued my investment journey, I came to realise that some companies, despite their track record of no earnings may, in fact, still make good investments.

This is because of two reasons. First, the company may be reinvesting for the future, and second, the company can easily turn a profit if it needs to. Companies that emphasise growth over near-term profitability put more emphasis on the future than on pleasing shareholders’ short-term wants. This is actually good for long-term shareholders who plan to stick around until the company has reached its full expansion and can start turning a profit.

Having said that, not all high-growth companies can eventually turn a profit. Investors who are looking at potential companies need to be able to separate the wheat from the chaff.

Why buy companies with high valuations?

Many investors use stock market screens to find potential companies to invest in. One filter that is commonly used is searching for companies that have a price-to-earnings (PE) ratio that is below a certain level.

For some investors, if the company does not have a PE ratio that falls within a certain range, it is completely ruled out as an investment option. Even major investment firms may sometimes abide by this rule.

However, in my experience, this may cause investors to miss out on great investment opportunities. Warren Buffett famously said, “It is better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

Good companies with strong growth potential are often priced at a premium to the market averages. This is usually because investors recognise the company’s strong economic advantage and potential for growth.

The Foolish bottom line

Having a framework in which we think about investing and filtering through stocks is usually a good start for any new investor. However, it is equally important that we are adaptable and able to recognise good investments that may not completely fit all our investments criteria. Investors who are adaptable can find stock market winners that others may be too afraid to invest in, increasing their returns in the process.

Meanwhile, are you worried about the overall state of the market? Do you know the 1 thing you should never do in the stock market? The Motley Fool Singapore's new e-book lays out a plan to handle market crashes, details the greatest advantage you have as an investor, and looks at decades worth of market data to bring you the smartest insights on investing. You can download the full e-book FREE of charge--Simply click here now to claim your copy

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.