Recent experience excepted, corrections are typically more frequent and regular than many would prefer, so investing should not occur without acceptance of this.
That said, it’s important to prepare, first by making the right investments, and secondly by adopting the right temperament.
The February market weakness may pass but the seed of concerns about increased volatility, rising interest rates and inflation has well and truly been planted, suggesting these concerns will be revisited by participants.
The right temperament is exemplified by Ben Graham’s Mr Market allegory. Think about your share portfolio much as you would an inherited farm on which you owe nothing, and which will generate a reasonable average return. There will be some terrible years, but they will be balanced out by some extremely good years too. The stock market, however, is represented by the neighbouring farmer, who leans against the gate each morning and yells out a price at which he’s willing to buy your farm, and another price at which he’s willing to sell you his. He doesn’t mind being ignored and he’ll be back tomorrow with a new price. Ben Graham noted, you are free to take advantage of him, if he’s in a particularly sombre mood, but you must not fall under his spell.
Provided you purchased a high-quality property, you don’t need to ever worry about the prices he’s shouting out. And that’s where making the right investment comes in. If you haven’t gone for fads, or companies that may or may not ever make a profit, then you should look forward to lower prices, and take advantage of them when they eventuate.
Many investors, especially those approaching retirement, believe they need to invest with the day of retirement in mind. This is a mistake. Even if you are retiring today, you potentially have 30 years of living to fund and so you will be a net buyer of stocks. Knowing that you will be a net buyer means you want lower prices in the future, particularly for those stocks you don’t already own.
For the stocks you already own, provided they are high quality businesses, the correction will prove to be temporary. That’s how you should be thinking about corrections.
Beware ‘irrational exuberance’
Here at Montgomery, we build portfolios from the bottom up. Having rejected the momentum that has driven prices well beyond our estimates of intrinsic value, we have been holding relatively large levels of cash for some time. Indeed, our high cash weightings have dragged on our returns over the last two years, but the cash has also delivered much lower volatility to our investors, who generally prioritise the protection of their capital over making the last percentage point in a rally. Especially a rally that has migrated from enthusiasm to irrational exuberance.
High quality company share prices, for example those for companies like CSL (ASX: CSL) and Cochlear (ASX: COH), have implied long-term growth rates that are simply impossible to deliver without interruption. Alternatively, investors have accepted discount rates that presume interest rates will never rise again. At the more optimistic end of the market, implied growth rates for companies like Afterpay (ASX: APT), A2 Milk (ASX: A2M) and Pushpay (ASX: PPH) are simply other-worldly.
A recent conversation with a small cap manager who had generated high double digit returns over the last two years revealed a reliance purely on momentum to support continued superior performance. When asked; “given they are well above any rational estimate of value, and sentiment is driving momentum, how do you make the decision to exit?” The answer was simply, “you’ll see them rolling over!”
Having watched, almost daily, the US 10-year bond rate climb from 1.36 per cent in mid-2016, to 2.84 per cent last week, we have been conscious of the need to be conservative in our adopted discount rates when estimating valuations. Consequently, we have been somewhat impatiently waiting for a setback in equities to deliver more rational prices.
Always focus on quality; those companies with high rates of return on equity, little or no debt, bright prospects for margins and unit sales volume and management with a solid track record. Pleasingly, quality companies have endured the recent market weakness better than many of the ‘concept’ or ‘themed’ stocks with underlying businesses only hopeful of generating profits or revenues in the future.
Searching for ‘all weather’ stocks
There are few true ‘all weather’ companies in the world simply because legislation or technology can always change in favour of a competing alternative. One of the few that comes close is French company Essilor (FRA: EI). The company enjoys a 40 per cent global market share in the manufacture and distribution of corrective eyewear. With 70 per cent of people over the age of 40 years, and 90 per cent of people over the age of 70 years, requiring corrective eyewear, the current market of over 4 billion people is growing daily. That’s about the longest growth runway I can think of, and the company generates excellent economics.
Domestically, the best examples include CSL – but it has been sold from the portfolio due to price appreciation, which has pushed the company’s shares well above our estimate of intrinsic value.
Australian private hospital operators also enjoy long runways for growth, notwithstanding recent setbacks related to negative press about private health insurance and the conflict between state and federal imperatives. Fiscal responsibility should ensure government legislation encourages self-funded healthcare and as greenfield developments mature, fixed asset turnover will improve and market sentiment towards operators will do likewise.
Roger Montgomery is chairman and chief investment officer at Montgomery Investment Management.
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