This time is different – or is it?
During times of severe market volatility, it is easy to lose sight of the opportunities created as sentiment and the fear of loss often drives the investment decision making process.
It is interesting to see the response from different investor profiles as the opportunist looks for a “quick buck” by buying into the selloff whilst the pessimist seeks risk free assets. Most people understand the principal of buy low and sell high but there is a lot more to it unfortunately than this simple philosophy if you wish to achieve consistent success investing in the equity market. Getting a “bargain” is not always the key determinant in your overall return.
We are currently dealing with a unique situation possibly never seen before in that global economies have effectively been shut down by a global pandemic. What makes this different is that it is very difficult to determine how long the quarantine measures will need to be in place to effectively halt the spread of the virus. The knock-on effect is severe and will in turn determine the trajectory of the recovery. It is fair to say a number of businesses will not survive while others will be less effected. A disconnect in the pricing mechanism (the market) from the fundamentals will create the opportunity for the long-term investor. In order to be a long term investor though it is imperative that your portfolio construction is in keeping with your long term objectives and you are never in a position where you are a forced seller in order to meet a capital drawdown. This requires forward planning and an honest assessment of your requirements from your investment portfolio over a 3 to 5 years period.
Assuming this is all in place this then allows one to focus on the most important aspects which will achieve a successful result over time. Whilst identifying companies with valuations that are compelling during times of market weakness, we think, is only one component that will drive returns over the long term.
If we take an extreme example and look at one of the most successful markets such as the S&P 500 over a prolonged period of time. Let us assume we were able to buy it at its cheapest in December 1917 just as WW 1 was commencing but then also successfully sell at a peak just prior to the dot.com bubble collapse. We could ascertain the contribution of our success and determine how much of it was down to our ability to market time and how much was down to the contribution of the companies’ ability to grow earnings over that period.
During this period the S&P achieve an annualized rate of return of 11.6%. The table below will show that at its low point the S&P was trading on a PE ratio of just over 5 all the way up to a high of 34. By way of calculation then it is easy to determine the contribution of the return by subtracting the annualised growth in valuation from the total return. You will note that 80% of the gain was in a fact a result of the company’s ability to grow so market timing is less a consideration than understanding the fundamentals of the companies that we own and their ability to grow over time.
Long term, the return that the company makes is more important than the price one busy and sells it for.
Return on investment,
growth rate and
superior cash conversion
These are all aspects of quality businesses that we ultimately look to invest in. Valuation is obviously a consideration in that we never want to overpay for these companies but there is more to consider than price alone.
The last decade has provided any number of reasons to sell and seek the comfort of cash or more price certain assets but as demonstrated in the chart above this would have been a costly decision when evaluating the opportunity cost of cash over time. What is interesting is that in the last 10 years this is not even the first virus lead market correction. It is easy to fall into the trap of saying that this time is different but we need to be honest when thinking back how many times we might have said that in the past.
Not all shares have performed equally over this period and it goes without saying we have some challenging times ahead of us. Our focus remains on understanding what we own on behalf of our clients and ensuring the portfolio construction is appropriate to deal with the unknown whilst still achieving long term objectives.
Above all we will continue to seek out the following:
Quality businesses with growth opportunities and high returns on invested capital,
Strong cash generation and growth opportunities to reinvest at high rates of return.
In times like these it is imperative not to rely on “special information” or unique insights but rather a structured and repeatable process – something that has served us well in the past.