Elio D’Amato* says savvy investors should be taking advantage of the stockmarket dip to get into quality names that normally seem out of reach.
The shift of the market towards value investing has been well documented.
With falling global macro indicators and geopolitical concerns on the rise, the market’s appetite for high-growth, high price-to-earnings stories has diminished.
This void has been replaced with the perceived safety of cheap stocks — the idea being if the market does have a pullback, then at current prices these have less to fall.
As money managers, our view on this line of thinking is that it is flawed and short-sighted.
In no way does it support our belief in the best way to accumulate sustainable wealth over the long term.
We encourage investors not to be lured into the fastest moving lane of investing traffic but instead to stick with strategies that are proven to work through many different cycles.
History has proven time and time again that in Australia companies that exhibit quality factors outperform over the long term.
When we talk about quality factors, we are referring to companies that exhibit properties in financial measures such as financial health, profitability, accruals and earnings growth.
A portfolio strategy based on identifying great companies that are exposed to manageable levels of financial risk, generating strong levels of cash flow and are both profitable and growing is the best route for outperformance over the long run.
It is for this reason that we are often comfortable paying a premium price for a quality business.
The alternative is to invest in companies with high levels of financial risk, generating meagre cash returns and not growing profits (if it was profitable in the first place).
Many of these “qualities” are exhibited in the stocks that can often reflect the most value.
While past performance is no indicator of future performance and there is no denying that value is the current favourite, history teaches us that eventually this cycle will end.
This means there is an opportunity for savvy investors to buy the dip and get into those quality names that until recently had always seemed just out of reach due to strong prices.
So how does an investor build the conviction to seize a quality opportunity in the face of a negative cycle?
These are some tips for those looking to make the most of a momentary shift in sentiment away from quality investing.
If you are seeking quality businesses that exhibit the elements described here, you are focusing on the best-of-the-best.
You can take comfort that in the face of price volatility, you are looking at the best businesses on the exchange that deserve the mantle of quality.
Believe in the numbers.
While things can change very quickly in business, you can anchor your decisions to the facts and use them to identify opportunities.
With the latest financials released from the recent reporting season, there is no better time to determine quality.
Don’t equate a company with quality just because the price has gone up.
Investors should not confuse a stock simply trading at a cheaper price as being an opportunity.
Sometimes negative volatility is simply a case of the price reverting to the (lack of) fundamentals.
Understand the active risks a company faces.
Should they pose a significant risk to the company retaining the quality elements, then it may be prudent to give them a wide berth.
Having a systematic and replicable means of stock selection is essential to ensure you don’t buy based on a hunch.
This helps block out the noise and avoid the doubt that stops investors seizing opportunities that are staring them in the face.
While quality will in time rebound, it is important investors hold a diversified spread of quality companies to give them the best chance of benefiting from any bounce while mitigating the risk of the occasional disappointment.
If you have identified a quality stock with strong numbers and manageable active risks, yet you are still worried that the cycle could stay lower for longer, consider averaging in and buying smaller parcels periodically.
Though you pay more in brokerage, it is an insurance policy against buying into a great business at the wrong time.
Be sure, though, not to spread your purchases out over too long a timeframe because when the cycle shifts, it will be swift.
Just as it was in December 2018 and the countless times before that.
* Elio D’Amato is Executive Director at Lincoln Indicators, a fund manager and creator of Stock Doctor.
This article first appeared at www.afr.com
