Rules Of Engagement
Storm clouds gathered over financial markets once more in January, with global markets enduring their biggest correction since the March 2009 low. Worries centred around three main subjects – bank regulation (triggered by Obama’s proposals), stimulus withdrawal (triggered by China’s recent measures) and sovereign default (triggered by the Greek government’s precarious financial position).
We suspect that ultimately global markets will resume their upward trajectory this year, given the considerable underpin provided by subdued inflation and very accommodative monetary policy. However, we also feel that the current investment environment is fraught with risks that are likely to make for bumpy markets for some time to come. All three of the worries above, for instance, are not worries that are likely to dissipate in a hurry. Politicians, sensing the brooding anger amongst their constituents are desperate to ‘bash the banks’ and in doing so are making as much noise as possible. How much of what is currently being discussed will ultimately make it into policy is impossible to know, but as with US healthcare reform over the last two years, the process is likely to be longwinded and noisy. In terms of stimulus withdrawal and sovereign default the likelihood of both will continue to grow as government finances become increasingly parlous. Carmen Reinhart and Kenneth Rogoff recently published This Time Is Different, a study of previous banking crises going back more than 200 years. Their historical analysis shows that recoveries from banking crises tend to be more muted and drawn out than those from inventory recessions (the sort more common in the developed world over the last 30 years). They also point out that the aftermath of banking crises are almost always associated with heightened levels of sovereign default, often running for several years. Given that the last decade (since the Asian and Russian debt crises) has been a ‘sea of tranquility’ on this front, the only direction is up.
In light of these lingering uncertainties, below are some investment ‘rules of engagement’ that we believe are sensible coping strategies for the diverse range of outcomes that lie ahead:
Look Down Before Looking Up
While the investment case for a stock often focuses on potential upside, we like to focus on potential downside first. Trying to compound your way out of a loss of 80%+ on an investment is no fun, so we’d rather not go there at all. One of our favourite tests is to try and ‘kill off’ a business. If things got really bad, how much could we lose from this investment? How robust are its cash-flows and financial structure? In particular, we favour businesses that have a good track record of being able to fund themselves with internally generated cash-flow, rather than an over-reliance on external funding. Funding weakness, from our experience, is the most likely way an equity investor can suffer a permanent loss of capital - the kindness of strangers is not always there when you need it most. Now, more than ever, the impact of regulatory change also needs to be factored into such worst-case scenarios.
Keep It Cheap
Buying cheap stocks is one of the best ways to avoid losing money over the medium-term. Most studies on ‘value stocks’ look only at the relative performance of buying value relative to the overall market, but buying cheap shares as a basic strategy is also very effective at reducing risk of long-term loss. We recently analysed the chance of losing money in a stock over five years based on starting value. Our universe was the UK market since 1995, so it covers a wide variety of investment environments from the bull market of the late 1990s to the market corrections of the beginning and end of the 2000s. The results are startling. In summary, buying more expensive stocks (with an earnings yield* of less than 10%) exposed you to a 50% risk of losing money over five years. Buying cheaper stocks (with an earnings yield of more than 10%) reduced your risk of losing money to 20%. The old adage ‘a low purchase price covers a multitude of sins’ holds true.
We are firmly of the view that diversification only has a beneficial effect on portfolio risk up to a point. Once you have a portfolio of 30 stocks or so, adding more and more stocks has only a negligible impact on reducing stock-specific risk. Furthermore, none of your market risk is eliminated. If the market drops 25% a portfolio of 200 stocks is just as likely to fall 25% as one with 30 in it. But as an investor, can you really have as much confidence in that 200th investment as you do in the first thirty? The best investors over the last decade achieved positive returns in negative markets by being focused and avoiding ‘benchmark-hugging’. We believe a focused portfolio of undervalued, solid investments is one of the best defences against the risk of ongoing difficult markets.
Given that almost none of the present value of dividends a company pays in its life (i.e. its true intrinsic value) will be determined over the next 5 years, market optimism and pessimism driven by short-term economic and industry conditions tend to exaggerate true value. These swings in sentiment are plentiful - the average stock price in the UK, including those of large companies, varies by more than 30% a year. For us, this fact has two implications. The first is a bit of an investment platitude - not to get too caught up in the moment and treat market volatility as a friend. The second is the harder one - to avoid a ‘stopped-clock’ investment mentality in terms of stocks held within a portfolio. As Will Rogers once said, ‘even if you’re on the right track, you’ll get run over if you just sit there’.
Please note, this investment view contains the personal opinions of Hugh Yarrow as at 1st February 2010 and does not constitute investment advice.
*we used operating profit to enterprise value as our measure of earnings yield, to put businesses with differing capital and tax structures on a level playing field.