9 ways to be prepared for stock price drops
Having been managing client’s investment portfolios for over 15 years now, I know there are very few people who like seeing the value of their portfolio go down. Loss hurts. But understanding how your portfolio and expectations can be positioned to survive and sometimes thrive in bear markets can reduce that stress.
The 9 ways to avoid stress during stock price corrections:
1. Understand the cycle
2. Own Quality businesses
3. Capital Independence
4. Share buybacks
5. Think long term
6. Don’t overpay
7. Turn off the noise
8. Micro not macro in retirement
9. Aussie parachute
Understanding the cycle
The stock market has a correction (more than 10% fall) on average every year.
The stock market falls on average 37% every 6.5 years.
Despite these chilling statistics, the markets have risen at a rate of approximately 10% per annum over 100 years. Apart from countries that have experienced authoritarian kleptocratic governments, the difference between each countries respective markets are surprisingly little over the very long term.
When markets don’t correct for a while, several people forget that it is as certain as the seasons and are shocked when volatility returns. And like the seasons, volatility will pass.
As soon as you realise that it is going to happen and it happens regularly, you start to understand its reality. Prepare for it even.
Humans are extraordinarily adaptable creatures. Once we know the paradigm of our existence, we can adapt to almost anything. The world we live in is that stock markets will have corrections on average every year, so understand and adapt.
Own Quality businesses
When you own some of the world’s best businesses, short term stock price movements have very little to do with the outcome of your investment. If you own a company with little competition that should double earnings in the next 5 years, and quadruple over 10, then fluctuations in price become far less important. A 20%, 30% or 40% movement in the price of a company can barely show up on a 20 year chart of a company that is growing earnings per share at 15% per annum.
This is illustrated by the following chart of Berkshire Hathaway class B shares over the last 20 years. They have gone from $50 to over $300, a multiple of 6 times.
Source: data from Morningstar.com Feb 2022
Business competition can be brutal for a number of companies. If you own shares in a business with no pricing power, stronger competitors, irrational competitors or in a shrinking market, then volatility can be against you.
If you own a dominant business which continues to take market share, has pricing power and steady or increasing margins, then volatility could be your friend.
In his excellent book “anti-fragile”, Nicholas Nasem Taleb talks about businesses that can not only do ok during downturns, however, do better because of the downturns. Building anti-fragility into your portfolio is not difficult if you know how. It starts with owning high quality businesses which increase their market share because of a weaker period.
A capital independent company is one that has sufficient cash to fund its expenses and has no net debt and not beholden to lenders. Companies that have net debt, could have their loans called in during a downturn. This will mean the company may have to go to shareholders to raise capital and thus dilute their holding and a permanent loss.
Citigroup is the ultimate example of this – see the chart below. They had to raise capital during the GFC and have never reached their pre GFC share price again. Locked in losses.
Data source: Morningstar.com 2022
It is the act of being forced to raise capital under duress that can cause the market fluctuations to become permanent.
Our recent analysis of our portfolio demonstrated that 87% of our portfolio had no net debt (more spare cash than debt) and are wildly cash flow positive. This is vastly different to the ASX50 which only has 17% with no net debt and are cash flow positive.
The beauty of companies with spare cash is that when the share price goes down, the cash becomes a larger percentage of the market cap. The safety of the business increases because cash as a percentage of the market capitalisation becomes a larger percentage.
“If you don’t have debt, it is very hard to go bankrupt” Peter Lynch
Other companies are incinerating cash. Borrowing large sums to fund growth whilst profits which are slim or non existent.
If you avoid leveraged and loss-making businesses, then share market corrections are rarely permanent.
Einstein reportedly said that compound interest is the 8th wonder of the world. I think that share buybacks are the 9th wonder of the world.
If you own a portfolio full of companies buying back stock, then a market correction should be rejoiced because you will be wealthier over time because of the pull back!
So, few think this way, which is also why many panic, but you should genuinely be hoping for weaker markets if you own uber cannibal stocks.
Stock buybacks by companies with spare cash are anti-fragile.
Think Long Term
If you own a business that can compound at high rates of return for decades, then worrying about what the stock will do this week or next is like focusing on the bug on the windscreen instead of the road ahead.
If you are truly thinking long term (something that few do), then you should be laser focused on the what the business is doing, not what the stock is doing. If the management is continually improving the business, then the stock price will eventually follow.
The list of the world’s wealthiest people is concentrated in business owners who have run or owned their company for many decades. They don’t buy and sell, so why should you?
Don’t Over Pay
Even the best companies in the world can trade at excessive prices during periods of market froth. 2021 was frothy.
If you understand the companies you own, then you should be able to make a relatively informed judgement of the intrinsic value of the business. If the company trades at significantly above your assessment of intrinsic value, then you should act (ideallybefore a correction).
For example, we own Etsy. Etsy is a wonderful business. We think Josh Silverman is a great manager. Our valuation of Etsy didn’t change significantly, yet the share price of Etsy ran up 70% in the space of 4 months after our purchase. We then reassessed our valuation and halved our holding near the recent highs.
Turn off the noise
Financial news networks are emotive beasts. They generally add little value to the long-term investor. Their goal is to enhance news to make it more interesting. This can increase the feelings that you have over stock market movements.
As Warren instructs on how to become wealthy:
“Close the doors. Be fearful when others are greedy and greedy when others are fearful.”
The first part of this quote, “close the doors”, is equally as instructive as the second part, yet few practise this.
Please note, this is not a way to reduce volatility. It is a way to avoid permanent wealth destruction and grow wealth over time through being resilient during periods of market froth.
Macro vs micro in retirement
Those that are drawing down capital must think about sequencing risk, that is, the risk that markets drop significantly early on in your drawdown phase. This requires that you have assets that can reduce volatility. A 70/30 portfolio or a 60/40 portfolio has done an excellent job of this over the decades. With bond yields rising yet still at ultra-low levels, a rethink of this structure may be prudent. Perhaps more cash or shortening duration on your bond portfolio is all that is needed? Sadly, this macro approach requires you to lower your expectations for returns going forward.
We believe that owning higher quality resilient businesses as the core of your portfolio can reduce some volatility in your portfolio. Companies such as Unilever, Johnson and Johnson, Reckitt and Pepsi are likely to experience far less drawdowns than high-flying loss-making tech companies. Few discuss this micro focus of stock specific selection to reduce risk, however managers such as Fundsmith and Magellan who own generally higher quality resilient portfolios have shown to have significantly lower drawdowns during market corrections.
The Aussie dollar, nicknamed the Great Australian Parachute is a wonderful mechanism to dampen drawdowns. The inverse correlation with the S&P500 is relatively strong compared to other asset such as gold, oil and property.
As a risk off currency during difficult times, we suspect that the Aussie dollar will continue to buffer US stock portfolios during most corrections.
Investing is a long road and if we focus on the potholes and small dips, we will lose sight of the bigger picture. The above tried and true portfolio tactics will over time improve confidence and yield returns with less stress. It has for us and our clients.