Is Bailing Out of Growth Investments Intelligent or Naive?

Investment Perspective – June 2018

Peter Flannery CFP AFA

 

 

“Neither the investing method nor the fundamentals of the business are right or wrong because the mood of the market is favourable or unfavourable toward the “stock”. That is because when you really think about it, “stocks” (shares) are all about the financials and the trading price, the share price…the cash up value. What matters more is the economics of the business” 

Peter Flannery

 

The other day a client emailed to my office and requested that they sell a substantial portion of their investment portfolio, repositioning it into US dollar cash.

I have not spoken to them about it (they are in an administration service, not an advice program) however I am not surprised because they have expressed anxiety and indeed some consternation around the dangers lurking in the global economy and how the markets might react.

I am only guessing, however I suspect the goings on in Italy and more particularly the potential contagion effect if Italy decides to pull out of the European Union (which just yesterday the finance minister in Italy said they will not do) could be something that might be on their minds?

I wonder too if it is something more primal?  That real fear around “share market crashes”, economic depressions and soup kitchen queues from the 1930’s that still makes some shudder when they think about it.

 

Who Do You Really Listen To?

I do from time to time receive queries from clients about what is going on around the markets, because they have seen something on the internet, they spoke to somebody or attended a financial meeting but usually it is the internet that unsettles them.  The evidence at times can be quite compelling and is always valid – the challenge is to establish the answer to the question…”It is valid; but is it right”?

As we joked many years ago, if you keep saying something long enough about the global economy and how there is going to be an upset, eventually you will be right. 

 

Markets Remain Somewhat Expensive

Those who understand markets know that currently, prices are elevated and not cheap. 

That said, in my opinion the trading prices of market indexes around the world, particularly the US, Europe and Australasia do not look significantly expensive when you consider price earnings ratios sitting around 21 or 22 in the US against the long term average of around 16.  Forward looking P/Es (taking into account projected earnings over the next 12 months) are estimated to be around 18 or 19, not that far away from 16. 

The ongoing challenge though, particularly for us Value Investors is that, however you look at it, prices are stretched. That makes it difficult to locate the value. 

This is especially so if, for example, the trading price of Alphabet (GOOGL) has increased 15% over the last year and that is a slow increase compared to Heico (HEI), up over 80% on last year.  If markets in general were unhappy or scared, we would not be seeing this type of increase in those trading prices.

Buying most well known “blue chip” type investments that are widely followed now, means you are paying above the underlying intrinsic value which carries with it the risk that:

  1. Should markets react negatively to a bit of news or an event, the price has further to drop.
  2. Longer term it is more difficult achieving above market returns when you pay too much for an investment in the first place.

 

Market Stability, The Friend of the Uncertain Investor

Those that don’t like volatility quite like the fact that markets are reasonably stable, even if it is at a level that means expensive buying.  Indeed, the market and investors as a whole do not really care that much about price and value.  They just want to make money and really dislike it when trading prices decline.

Then there are those few of us who adopt a different approach whereby we like to invest in the underlying business and are much less concerned about trading prices rising and falling. 

For us, the price declining means an improved entry point which we like (see number 1. and number 2. above) because we know that the strength of the underlying business is what will generate our wealth long term rather than trying to “second guess” or outsmart the markets or fickle trading prices.

 

The Market Bet

This brings us back to the couple that have taken a strong position … a strong bet if you like, against the market.  There is the possibility that they are right.  The stakes are quite high in Europe and should that situation get out of control, the ramifications are potentially quite significant…remembering of course that for most people, when it comes to investing their money, price and value are the same thing. 

 

Investing Behaviour and Investment Results

So, be it Europe or under-funded emerging markets or trade tariffs, or global debt levels, there are many potential economic disasters that can happen.  They often spring from a direction that is not obvious.

Anyway, when most people see the cash up value of their investments declining, they feel that the real value of their investments is also reducing…their hard earned wealth slipping irretrievably away.  When that happens quite quickly, uncertain investors can become very scared.  They can make investment decisions that depart from best practice, to their long term investing detriment.

 

Down is More

On the other hand, for those of us that are invested in businesses rather than playing the stock market, lower prices are exciting – we like it.  The further down, the more we like it… down is more!

So, will the couple who have taken a strong bet against the market be right?   They are not running off to the bank with all their money like others have done in the past – never to return.  They look like they are taking a defensive position and wanting to be prudent.  They might be. 

Also, it’s difficult to get into too much trouble sitting in cash, at least in the short term.  Longer term though it may not work out so well for them because cash and fixed interest are poor stores of long term wealth. 

It is highly unusual for investors to buy growth investments when trading prices are under pressure and market sentiment is negative.  That behaviour is counter-intuitive.  Humans are generally “wired up” for fight or flight, fear and greed. 

The challenge might be knowing when to get back into the market again.   This action might only take place after the market has lifted by 5% or 10%.  If that is the case, not only have they had the expense of the brokerage to sell, then the brokerage to get back in (although admittedly it’s not massive), but also the opportunity cost (they were late getting back in) of say 10% across the total value of the portfolio is a decent sum of money.

Should “Europe” or some other event cause the markets to “crash and burn” soon, then they will indeed be right and their exiting now will look highly intelligent. 

People do buy and sell, taking big bets against the market.  It is just that there is minimal evidence showing that there are many who are more successful long term than if they had just maintained their original positions (assuming they were of suitable quality).

The other way to look intelligent and worldly long term is to invest as a business owner (avoid playing the stock market by trying to outsmart  the markets).  Have enough cash to average down … take advantage of lower prices … adhere to the investing strategy. 

 

“ Buy a business, don’t rent stocks”

                                                        Warren Buffett

 

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