The brisk rally to start the fourth quarter aside, equity prices seem to be on a relentless downward grind. With nearly every new stock pick destined to be a disappointment, it makes one question how to invest in this kind of market.
No doubt, few stocks can buck the pressure from steadily rising interest rates and stalling economic growth, let alone the squeeze from tighter labor market conditions and higher input prices. Third-quarter earnings season is just around the corner, and analysts are trimming their estimates almost across the board: excluding Energy stocks, earnings for the S&P 500 companies are projected to dip 3.4% from a year ago, based on Factset’s Earnings Insight. Analysts are projecting 7.9% earnings growth for 2023 but are trimming these numbers just the same. By this time next year, it’s possible that 2023 will be a down year for company profits. None of this is supportive of stock prices, even at the historically middle-of-the-road 15.4x price/earnings multiple for the broad market index.
The dimming fundamental picture is getting little help from the macro realm. A war in eastern Europe pressed by a losing nuclear power, the surging dollar, an unsettling political atmosphere and tense trade and military relations with China only seem to lead the daunting and seemingly ever-expanding roster of headwinds.
[text_ad]
Knowing that just about every new stock purchase will be a near-term loser, how does an investor select ideas to buy? And, why even bother? Aren’t cash or short-term Treasuries better homes for capital?
How to Invest in These Market Conditions
In these market conditions, the sensible investor will set aside the macro-driven worries to focus on individual companies and their share valuations. While other investors and traders ask: is this a “risk-on” or “risk-off” day, which currently leads them to sell aggressively, the sensible investor asks: is this a solid company trading at a discounted valuation? If, say, Gates Industrial Corporation (GTES) is a well-managed, safely capitalized and highly profitable company in a critical market niche whose shares are trading at 8.5x earnings, does it really matter in the long run what investor fears are today? One can be reasonably confident that Gates will still be prosperous five years down the road. There are many other companies like Gates currently trading at unusual discounts.
This approach to investing may sound out of touch or perhaps naïve. At best, some may call it “contrarian.” In reality, it is the strategy pursued by most of the successful long-term investors, including Warren Buffett, chair of Berkshire Hathaway. The core of this mindset is captured in his saying, “The market is there to serve you, not to guide you.”
To fully appreciate this mindset, ask yourself, “how is the market serving me?” If your answer is, “poorly, as I am losing a lot of money,” you are thinking conventionally. Consider an alternative answer, “the market is doing me a real favor, because the more it goes down, the cheaper I can buy the shares of my companies.”
Using a thought experiment to press the point to the extreme: if you don’t need to tap into your capital for 10 or 20 years, you might actually want stock prices to go to near-zero. In this environment, you could buy vast stakes in high-quality companies for almost nothing. Of course, for prices to be this low the conditions would have to be almost cataclysmically bad, and no one wants that. But to illustrate the point, the experiment is powerful.
So, going back to the opening question of how to invest in this kind of market, first, search through the market for quality companies with enduring franchises. The mere process of searching for new ideas is exceptionally valuable by itself. When you find companies that you want to buy, further narrow your list to those trading at highly attractive share valuations. Then, buy small amounts, perhaps a quarter or even an eighth of a full position. There is no need to be aggressive, but nevertheless buy some. Yes, the shares will likely go down in price. But, let the market serve you: as the valuation becomes excessively pessimistic relative to the company’s fundamental outlook, add more at the lower prices. This is how some investors generate returns vastly better than the overall market.
At the Cabot Undervalued Stocks Advisory and theCabot Turnaround Letter, we help investors navigate the equity markets using a common-sense, value-oriented approach that emphasizes out-of-favor stocks of companies with real value. Let us help you sort through the market to find them.
[author_ad]
