Update on Market Conditions

posted on August 9th, 2011 by Bellmont Research Team

I thought that with the current hysteria engulfing the markets, a little perspective on what’s going on might be beneficial.

Australian shares have now officially entered a ‘bear market’ with the major benchmark indices falling more than 20% from their recent highs. The cause of this rapid sell-off has been a combination of economic issues coming out of the US and Europe, including the downgrading of US sovereign debt by ratings agency S&P, downward revisions to US economic growth numbers, and growing fear of the Eurozone sovereign debt issues spreading to Spain and Italy.

There is no doubt that these issues are real, and have potentially serious implications for the speed of global economic growth going forward. But, it is important every now and then to take a step back, and consider once again what it is that we’re actually doing as investors.

When we buy shares in a company, we are purchasing a share in that company’s earnings. And importantly, we’re purchasing a share not only of this year’s earnings, but all future earnings of that company from this day forward. So when we look at any economic issues, it’s always important to relate those issues back to their likely impact on the future earnings capability of that business. The question we need to ask at the moment then, is whether the economic issues that have caused this market sell-off have actually reduced the total future earnings of the businesses that we invest in by 20% or more? If the answer is no, then the decline in share prices may represent a great opportunity to acquire quality companies at more attractive prices than they are usually available at.

Interestingly, when you look at previous periods of severe economic shocks, despite their impact on the level of overall economic activity, many of Australia’s top quality companies saw their earnings continue to grow each and every year. Companies from a diverse range of industries including retailing, healthcare, engineering services, information technology, telecommunications and many, many more grew both their earnings and earnings per share every single year throughout the GFC. Yet, their share prices were not immune – falling by as much as 50% or more in many cases. Smart investors, rather than selling into this panic, used this period as an opportunity to pick up quality stocks at extremely attractive prices.

It’s also worth noting that Australia is far better placed than most other nations to respond to any economic slowdown. Our interest rates are by far the highest in the OECD, which provides the Reserve Bank with significant ammunition to reduce rates and stimulate demand if necessary. If this occurs, it’s highly likely that one of the other major headwinds for Australian businesses of late – the high Australian Dollar – will moderate as well, further improving conditions for domestic companies. Our federal debt is also far lower (at roughly 20% of GDP) than any other major developed nation (the OECD average is around 100%!), meaning that our government still has the option of providing fiscal stimulus if the economy continues to deteriorate. And finally, although our financial markets are still tied closely to Europe and the US, our economy is far more closely tied to the fortunes of Asia than that of the western world. In fact, China is the destination for approximately 25% of our exports, with the US receiving only 4%. In short, while we’re not immune from what’s going on, we are far better placed than most other nations.

So, given all this information, what is the appropriate action? Ultimately, as I don’t know your personal circumstances I’m unable to provide personal advice to you. But there are some general rules that it would be worthwhile paying attention to:

  • Don’t panic – Consider the situation rationally, and attempt to determine what impact these economic events are likely to have on the businesses you are invested in.
  • Be careful with leverage – Leverage is a double edged sword. While it can maximise your returns in good times, in bad times it can force you to sell at exactly the time when you should be buying. This applies both to personal leverage on your own investment portfolio, but also to leverage employed in the companies you invest in.
  • Consider your investment horizon – Anyone with a short-term investment horizon (less than a year) should be especially cautious, as the short term direction of markets is impossible to predict. Investors with a holding period of at least 3-5 years can afford to be more opportunistic, and take advantage of any short term over-reactions in the market.
  • Buy quality – If you’re looking to buy shares in this environment, look at companies that have a history of stable earnings, low debt, a solid competitive position, quality management and have preferably shown their ability to survive and even thrive in previous downturns.

And finally, take heed of the words of wisdom of some of history’s greatest investors

“Be fearful when others are greedy, and greedy when others are fearful” – Warren Buffett

“The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell” – Sir John Templeton

Good luck, and invest wisely.

Peter Bell
Director



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