During times of increased volatility, I get an unusually high number of inquiries from clients and other friends about what they should be doing to prepare for a possible market downturn. "Do I sell now? When should I sell? Where should I put the money? Do you think this will be a big one, Michael?" The anxiety is exacerbated by a number of external risk factors that are covered ad nauseam by the various media outlets: Ebola, Ukraine and Russia, Hong Kong's independence, Europe's stagnation, slowing growth in China, or ongoing strife in the Middle East. Investors are barraged by bad news daily. Major news stories lead directly to one of the biggest pitfalls of investing: becoming distracted by all the noise that may not be relevant to a long-term investor's particular situation.
It is quite natural and rational for investors to become alarmed when the major market indices shed over 5% in just a few weeks. We like to say that investors don't mind volatility as long as it's upside volatility. But if we put the recent volatility in context, there really shouldn't be much cause for alarm. The S&P 500 is still up over 180% from the financial-crisis lows (March, 2009). Last year, the S&P 500 produced a total return (with dividends reinvested) of 32.4%, and total returns for 2014 remain positive (+3.2%) despite the recent selling pressure. These are massive gains, the likes of which have seldom been seen in such a short period. The astute among you may respond that such massive gains should almost reflexively lead to taking some chips off the table. Perhaps that is true, but there are other factors to consider.
Nobody can effectively time the markets with any degree of consistency or precision. This is especially true if one incorporates the cost of capital-gains taxes in the equation. And it is especially, especially true in the current interest-rate environment, which offers very few alternatives to generate an acceptable return on your money. While we don't want to rely too heavily on the "TINA" philosophy of investing ("There Is No Alternative"), investors do have to consider where they will invest the proceeds of any stock sales (after paying capital gains taxes, of course). So, those long-term investors among you should only consider significant selling if the following conditions are met: you have near-term liquidity needs for funds currently deployed in long-term investments or if your asset allocation has exceeded your planned limits.
But back to the original question of how to position for increased volatility ahead. My first, and often best, advice is to maintain your composure. Decisions that are made under duress or in response to any emotion are usually poor decisions. Our best defense against sharp corrections in the stock market lies in the construction of the portfolio itself. For the past couple of years, we talked extensively about our "defensive" posture. Times like these are when this defensiveness pays off. How do we determine whether or not a company is defensive? We spend expensive amounts of time evaluating the fundamentals of the companies we own. For inclusion in FMW portfolios, companies must possess a list of attributes that we believe will lead to both participation in bull markets, but perhaps more importantly, superior financial performance during periods of economic weakness.
What is included in our list of attributes? The most important factors to consider with regard to a company's defensiveness are its balance sheet strength and cash flow generation. We seek companies that have low debt levels, strong cash flow (and free cash flow conversion rates), and the ability to self-finance operations (if need be). Many times these companies tend to operate in more defensive industries. For example, Health Care and Consumer Staples companies should enjoy strong relative financial performance during economic downturns because their product and service offerings are less discretionary. Consumer Discretionary companies, on the other hand, will likely suffer outsize revenue declines during economic recessions.
Secondly, we look for companies operating in industries with attractive secular growth prospects. For instance, few would argue that the secular outlook for office-supply retailers is positive. This sector of retail is experiencing intense competition from web-based retailers like Amazon, while at the same time suffering from lower consumption of copy paper and toner. On the other hand, the natural & organic food industry is growing at an annual rate of 10%+. We believe an industry growing this fast has room for several successful competitors, and thereby offers some margin for error. To identify these types of industries/companies, we look for high barriers to entry, deep-rooted customer relationships, a defensible or enduring cost structure advantage, and/or proprietary technology.
Next, we take a long look at a company's track record, with particular focus on how the company performed during economic recessions. We look for strong historical growth rates in sales, margins and earnings, and we seek companies with relatively high returns on capital. Along with this track-record evaluation comes an appraisal of the current management team. While past performance never guarantees future outcomes, we believe it makes sense to put our clients' money with tried and true operators who have been there before. We also look at market share trends, and we favor companies with significant (and growing) market share and structural competitive advantages.
Finally, we rely heavily on valuation analysis. We try not to mistake a great company for a great investment. In other words, we do not like to overpay for a stock, and the risk/reward proposition must be favorable. Our heavy focus on valuation usually provides downside protection in volatile markets. Stocks have less room to fall if the valuation is supported by metrics such as relatively strong revenue, earnings, book value, cash flow, or dividend yield.
In recent years, many media pundits have opined that a strategy of "buy and hold" is dead. They seemingly advocate for an approach, characterized by heavy transacting, that assumes one can see into the future. We believe nothing could be further from the truth. In fact, the increased market focus on short-term results creates better opportunities for those of us who remain long-term focused. Those with a long-term focus are able to acknowledge that they can't read the future any better than anyone else. What we can do, though, is the homework required to identify and invest in companies operating in attractive industries with seasoned management teams.
Investing has never been easy though it has enjoyed some easy periods. The successful are separated from the unsuccessful when they get shaken out of good positions at the scariest times. Warren Buffet doesn't panic, and neither do we. Fact: markets from time to time go down. To date, US equity markets have recovered from every downturn and eventually went on to exceed their previous highs. The growth of the American and global economies are the underlying drivers for most all equity investments. A clear discipline, dogged research, and dispassionate assessment are an investor's best friends. If you need some help, please feel free to give us a call. Hang in there!