Framing the Challenge

Following last week’s Market Commentary, I was asked how we can remain fully invested in a market fraught with danger. It’s a legitimate question, and so I feel compelled to respond.

First, we would say that no one can time the market over the long-run. It is extraordinarily rare for one to get out at the top and then back in at the bottom. Trying to do this and failing can be an extremely expensive mistake. Alan Greenspan, the head of the Federal Reserve at the time, noted the irrational exuberance surrounding the U.S. stock market in 1996. This would have been a good time to sell, right? If you had, you would have missed a 33% gain in 1997, a 29% gain in 1998, and a 21% gain in 1999! It would have been quite painful to watch one’s $1 million account stay at $1 million when it could have been over $2 million in three years. This is especially true when all conversations at neighborhood parties centered on how much money everyone else was making on their dot.com stocks. So what might one have done in 1999? Capitulate and try to join the party? If so, guess what happened next? The dot.com bubble burst, 9/11 happened and the stock market lost roughly 50% of its value over the next several years! At this point, do you hang in there now that your $1 million has become $500,000 or do you sell in a panic near the bottom because you can’t afford to lose anymore?

Though the above example is perhaps a bit extreme in that this fictional investor did everything perfectly wrong, it does highlight the reason that the average individual investor’s performance is significantly worse than the returns of stock indices, such as the S&P 500. The reason is failed market timing! The roughly 10% annualized returns generated by the U.S. stock market since 1926 were not generated from market timing. This return was generated despite the Great Depression, World War II, awful inflation in the 1970s’, the dot.com crash, and the Financial Crisis of 2008/2009. We can’t predict future returns but we do know that timing the market is impossible to do consistently.

Second, we should say that the stock markets are very rarely uniformly overvalued. Rather, frothy stock-market valuations are usually the result of heavy investor concentration in certain stocks and sectors of the market. In other words, the tendency for investors to pile into what has been working (and avoid what has not) is what usually provides the fuel for aging bull markets and/or bubbles. Leading up to the dot.com bubble, investors heavily favored technology and internet-related companies, many of which had yet to show any profits. Leading up to the Financial Crisis, investors bid up highly levered financial and real estate companies that benefited from the housing bubble, as well as energy stocks that benefited from oil prices rising to $148 per barrel. The unwinding of these concentrations was the cause of the nasty bear markets that followed. But that’s the nature of the beast. Chuck Prince put it best when he said, “as long as the music is playing, you’ve got to get up and dance.” Indeed, simply following firmly established market trends can, at times, be very profitable. When “irrational exuberance” is happening, it’s very alluring. But when the music stops, it can become very expensive. Anything that can go up really fast can go down even faster.

Today, the S&P 500 is at nearly an all-time high and trades at 18x 2019E EPS, and 16x 2020E EPS. These multiples are a bit above the long-term averages. However, the market’s overall valuation doesn’t tell the complete story. Within any market, there are expensive stocks and inexpensive stocks. Many tech stocks fall into the “expensive” camp. Amazon currently trades at 73x 2019E EPS. Netflix, which is dropping as we write after losing U.S. subscribers for the first time in 8 years, trades at 100x 2019E EPS. Salesforce.com trades at 57x 2019E EPS. There are many, many other large cap tech names that look quite expensive. In addition, a whole host of unprofitable tech companies have come public (executed an IPO) in the past 6 months. Though we don’t see a bubble in the overall market, there are areas that have started to look quite expensive. To be clear, there are many great tech businesses. However, a great business can end up being a bad investment if the price paid for the business is too high. Meanwhile, there are plenty of solid, blue-chip companies with attractive growth prospects and good balance sheets that aren’t as exciting as the aforementioned names and thus trade at very reasonable P/E multiples.

As the market makes new high after new high, experienced managers should turn to companies that are better able to withstand the inevitable future economic and market volatility. Historically, investors have flocked to companies providing stability, visibility and transparency as the waters become choppier. As the tide turns, investors will begin to rotate into blue-chip companies with rock-solid balance sheets, experienced management, limited debt, solid cash flow, no need for external funding, and relatively steady profitability. These are the types of companies we at Farr, Miller & Washington favor at all times, but these investment attributes are all the more important during periods of increased economic and market uncertainty.

The most obvious example for the importance of management and financial strength during troubling times is the pure-play investment banks leading up to the Financial Crisis. Bear Stearns, Lehman Brothers, Merrill Lynch, Morgan Stanley and Goldman Sachs had increased leverage up to 30- or 40-to-1 in an effort to goose profits. Their balance sheets were a disaster waiting to happen. These companies also had huge off-balance sheet exposure in the form of swaps and other derivatives with, in many cases, poorly capitalized counterparties. When the crisis hit, these companies were forced to accept highly dilutive lifelines from the federal government as their stock prices plummeted. Only two of the five remain independent today.

A second critical element to investing for capital preservation is to ensure that valuations for prospective investments have sufficient cushion to withstand a deterioration in the operating environment. In other words, valuations should be undemanding enough that the downside risk is limited even if things take a turn for the worst. For example, downside risk may be limited for companies and sectors that offer relatively stable earnings streams, cash flow and high dividend yields. Interest rates usually decrease in the period leading up to recessions. Therefore, it might make most sense to rotate into sectors, like Consumer Staples and Health Care, that are less cyclical and will be looked to as sources of dependable income as interest rates fall. These companies sell products and services that we can’t live without, and so their earnings are likely to hold up well. Just as important, their dividends will act as downside support for their stock prices.

Our process consists of evaluation of the investment and economic landscape; diligent, in-depth research into the various industries and companies on our watchlists and in our portfolios; and constant re-evaluation of our investment theses. Owning individual securities, both stocks and bonds, allows us the flexibility to more actively pursue our investment discipline and exploit the efficiency of time. Exploiting the efficiency of time means that our long-term focus provides us the opportunity to invest in companies that more short-term oriented investors are unwilling to consider. In an investment world that has become increasingly short-term focused, we believe that our buy-to-hold strategy provides a significant advantage for our clients.

To return to the beginning question: How do we stay fully invested in a market fraught with danger? Our job, our duty, is to recognize the dangers, anticipate potential threats, and secure opportunities for our clients. Ignoring risks and hoping for the best is gambling. Allowing risks to derail one’s investment discipline is tomfoolery. Evaluating risks and choosing a path forward based on research and a sound financial thesis is sound investing.