By Neels van Schaik of Alphen Asset Management.
Significant rallies in stock prices usually draw in huge amounts of new cash towards the peak. That is how stock markets work and that is how human nature works. Given the rally we have witnessed since the market lows in November 2008, investors find themselves in a predicament. Is this the correct time to be buying stocks?
Commentators and investment pundits have flooded the media with articles and information regarding the state of the world economy and the uncertainty the world faces regarding government debt, geopolitical instability, consumer deleveraging, and the rest of the jargon that goes with it. This is held forward as a key reason why you have to be cautious to commit new capital to the market.
Although all these concerns are valid, you will very seldom, if ever, find a period where global macro forces are in such a state of equilibrium that capital commitments to stocks can be done with any degree of certainty. We can let our minds drift back to the late 1940’s, when Europe was completely broken after World War II and capital was scarce. Looking at the world and the future at that point in time could not have inspired too much hope for investors.
Another example is the seventies which saw one of the worst periods for stock investments. Between 1970 and 1978 the S&P500 delivered a cumulative capital return of 7% and adjusted for inflation a complete annihilation of capital. By the end of 1978 any investor in stocks could have been excused for not having too much optimism on the outlook for stock returns, given the returns over the preceding eight years.
The world has become a very small place and investors and consumers are even more bombarded now with information on financial markets on a daily basis. I am not sure that all this information necessarily adds value to investment decisions though.
We would recommend that the investor’s sole justification for being exposed to stocks, or not, should be the price of the companies looked at, relative to the value of those businesses. This is why we deem a bottom-up approach as the best way to construct a portfolio. This will focus your attention much closer on the investment and valuation criteria you look for in an individual business and on finding the companies that adhere to these criteria.
Looking at the valuation criteria that we believe are very important, we currently consider the market to be fully valued to expensive, and we would caution investors against committing new capital to the stock market in any aggressive way. Investors need to realize that a very important way of measuring risk is the possibility of permanently losing capital, and this is related to the price you pay for any asset. Permanent loss of capital can be avoided through a conservative investment approach and avoiding overpaying for companies.
That is why investors should, in an almost perverse way get excited about market corrections, as these are the ideal buying opportunities, as opposed to after the market has rallied 50%. This approach obviously requires patience and diligence and you can be wrong for long periods, but in the long run will be more rewarding than the low real returns and possible capital erosion that will result from the alternative approach.
The companies we do own, we believe, have not fully discounted their full earnings potential and the high and consistent returns they generate on their invested capital is not fully discounted in the valuations of the companies. Also, we favour companies where the dividend yields are attractive and sustainable.
The most important aspect of investing though is finding a process that is sound and logical and that is consistent in the results it generates. It is also important to realize that no-one has access to the Holy Grail of investing (although some might believe they do), and your estimate of a company’s value at any point in time is your best assessment of the information at your disposal. Some investors might look at different factors, but the most important issue is to stick to the process that works for you.
As John Maynard Keynes once said “it is better to be roughly right than precisely wrong”.
Source: Neels van Schaik, Alphen Asset Management, February 24, 2010.
