Cleary, the increase of Coronavirus outside of China has driven a swift correction in global and domestic equities. Equities markets have now given up most of their gains of 2020, and many are now down on the year.
The markets have re-assed the impact of Coronavirus in terms of supply chain interruption, consumer spending interruption and, in turn, short-term equity earnings downgrades. In very quick time (less than a week), markets have gone from a glass half full approach to Coronavirus, to a glass half-empty approach. Inside that major reversal of investor sentiment we have seen a somewhat indiscriminate sell off in global and domestic equities: a classic “risk off” move away from the equity asset class to the sidelines.
These moves also remind you of the increasing short-term influence of passive funds, such as Index Funds and ETFs.
The indiscriminate nature of the sell off, where most sectors are down similar percentages from recent highs, does offer investors with a medium-term investment horizon opportunities to deploy cash and increase the quality and duration of portfolios.
When you get an indiscriminate sell off in the equity asset class, I always describe it as going to the equivalent of a clearance sale at a department store. In the clearance sale, everything is marked down, including quality goods that are very rarely on sale.
In equities, just like in retailing, quality is very rarely on sale as such. In fact, quality only stays on sale for a very short period.
As I said in the opening, I see corrections as firstly a chance to deploy cash at an attractive margin of safety. That’s the first move: put some cash to work selectively.
Most investors won’t do this. They will hoard their cash feeling “things can get worse”. Sure, they can get worse but I always remind myself “it’s a market of stocks, not a stock market”.
When “the stock market” in risk off mode allows me to buy great individual stocks at a margin of safety, then that is an opportunity I must take.
Stocks are daily priced, but the companies I own and want to buy more of will be generating profits, growth and dividends for the next two decades. Short-term corrections are opportunities to buy long-term cashflows, profits and dividends. Never lose sight of this. Equities are a long-duration asset class with daily pricing. In fact, they are priced by the second by high frequency traders. Therein lies the opportunity.
It’s also worth remembering that these Coronavirus interruptions to global growth ensure that the return on cash is not going up. In fact, interest rates are far more likely to be lowered again in Australia, and globally, in response to Coronavirus’ economic implications. Bond markets are already telling you this.
Central banks are also likely to pump further liquidity, and overall liquidity in the global monetary system, will be increased through this period. Therefore, while cash is the outperforming asset class of the last four days, it is highly unlikely that cash will outperform high quality global and domestic equities on any measure period over the medium term.
I genuinely believe this is an opportunity to deploy cash into the highest quality equities at a margin of safety, and that is exactly what I’ve been doing with my fund. Australian SMSF investors should also consider their very high cash positions (25% to 29%) and consider whether the market correction is giving them the opportunity to generate better risk adjusted total returns than cash from these levels. In reality, I only have to find stocks that can outperform a zero real return on cash from here. I believe that is highly achievable both globally and locally.
The second action I am taking is to make sure I come out the other side of this correction owning the highest quality portfolio I can. I don’t believe you diversify further in corrections…you further concentrate your portfolio in the best companies you can own. I want to emerge from any short-term correction owning a concentrated portfolio (20 stocks) of simply the best long duration, high barrier to entry (wide moat), industry leading, balance sheet strong, experienced management, structural growth stocks.
I want to use the “clearance sale” to further increase the quality and duration of my portfolio. As I said, I want to come out the other side of this owning the best of the best, taking the quality of the portfolio right up while quality is indiscriminately on sale. I’m going to be ‘active’ in a ‘passive’ sell off.
If you don’t agree with me about putting some cash to work, and that’s your choice, I think you should consider increasing the quality and duration of your equity portfolio.
Resist the temptation to buy “cheap” cyclicals or price takers. When the market recovery comes, it will be led by the best businesses who are largely unaffected in an earnings and dividend sense by Coronavirus interruption.
Resist the temptation to buy the “weak”. They will remain weak and structurally challenged. Buy the strong. They will emerge from this even stronger is my opinion.
I know it’s hard psychologically to fight the greed and fear cycle that equities illustrate in the short-term. However, if you want to generate medium-term total returns in equities you have to fight your natural instincts and act in short-term corrections.
Ask yourself this: if you had a wallet full of cash, would you run away from a clearance sale?
In summary, and I am repeating myself deliberately here, I believe there is stock specific investment opportunity here in this clearance sale.
What I am doing for my fund is deploying cash reserves with the intention of getting fully invested into this correction. I am also increasing the quality and duration of the portfolio with the intention to come out the other side of this correction owning a concentrated portfolio of the best businesses in the world. Businesses such as Microsoft, Alphabet, LVMH, Nike, Amazon, and Estee Lauder, to name a few.
The table below reminds you of the long-term outperformance of the highest quality businesses as measured by the return on invested capital (ROIC) they generate.
I leave you with one final thought. It’s about time in the market rather than trying to time the market.
The chart below illustrates the underperformance you generate via missing the biggest up days in equities.
The blue line is the MSCI World Equity Index over the last 15 years. It has returns +7.1%pa over 15 years.
However, if you’d timed the market wrong and gone to cash and then missed just the 5 biggest up index days in the last 15 years, your return dropped to just +4.8% pa.
If you missed the 10 biggest up days, your return dropped to just +3.1% pa.
If you missed the 20 biggest up days, your return dropped to just +0.8%, which was lower than OECD G7 inflation.
If you missed the 30 biggest up days, your returned was negative -1.1% pa. Of course, the biggest up days come after the biggest down days. That is why history tells you to selectively deploy cash in periods such as right now, if you want to capture the compounding effect of equities. I want to make sure I am fully invested in the world’s best businesses while they are on sale and before the index recovery starts.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regard to your circumstances.