The next step for equities
The events of the past several months have been unsettling for investors. With mounting concerns about a global recession and a near shutdown of the capital markets, the FTSE 100 has delivered its worst YTD return since 1931. The market has been characterised by fear, panic and forced selling, as mutual funds and levered hedge funds face record redemptions. For those that remain in equities, the top objective has been safety, as cash-rich companies have outperformed those with arguably better growth prospects.
From 2003-2006 we experienced a benign market period. Very strong global economic growth was coupled with easy access to cheap capital and this led to both broad profit acceleration and low volatility returns. Investors took on more risk and there was little distinction between the valuations of high and low quality assets. By just passively investing in indices, investors saw healthy returns. Now however, the cycle has turned and we have an environment of great uncertainty to navigate. Investors who are traditionally heavily exposed to equity risk are likely to be reviewing their positions very carefully and considering their next move with some trepidation. A period of enhanced volatility is not necessarily all bad news – it can also yield opportunity. However, we need to be careful, cautious and considered in any move we make so it pays to re-visit a few equity investing maxims: 1. Wealth is created through the long term ownership of a growing business – therefore we should stick to investing in businesses which are well positioned to prosper despite the market environment. By focusing on these fundamentals, we avoid the emotion driven trades which characterise the current market. 2. Trying to predict the future is dangerous –a good equity manager will certainly have a view on the macro environment but we can’t predict: the length of a recession; the impact and effect of the TARP (Troubled Assets Relief Program) and nationalisation of banks; stock price movements and outcomes based on normalized earnings or historical regressions – we are operating in extraordinary times. 3. You need an active team seeking out value for you – there are likely to be larger gaps between the winners and losers in this kind of market so the ability to process new information, anticipate change and make sound judgements is incredibly valuable 4. Look for sustainable growth criteria – previously characteristics like management quality, long term prospects and a strong business franchise were less crucial than they are now – who cared about free cash flow when capital is cheap and easy to access? That was then; this is now. In the current environment of slowing economic and profit growth, margin pressures and a credit crunch, quality companies that can increase market share, sustain earnings growth by capitalising on secular growth drivers, exert pricing pressure to maintain margins and self finance their growth, should further extend their competitive advantage, positioning them for future growth. While sentiment ebbs and flows, we believe it pays to stick to this discipline because the market event-ually recognizes the value of companies who are well run and resourced. What we shouldn’t do is make any move in a hurry or try to predict the timing, catalyst or degree of any kind of market correction. The question on everyone’s lips has been “where is the bottom?” We would contest that this isn’t the right question, instead we should be asking which companies are poised to outperform. Certainly, some companies will weaken further in this environment, and others will fail. Still other companies will strengthen, widening their competitive advantage and improving their growth prospects. These are the companies that we should be seeking out and holding onto in portfolios. These strong franchises, divined through in-depth research, can deliver meaningful absolute returns for an investor with a three-to-five year time horizon. So while we can’t call the market, we can say with confidence that we believe the right companies are looking unsustainably cheap at the moment.
