“When the central bank steps on the brakes, something goes through the windshield.” This vivid analogy, provided recently by Bob Michele, head of J.P. Morgan’s Global Fixed Income, Currency and Commodities group, effectively captures investors’ fears about the aggressive pace of interest rate increases while simultaneously making a case for a value investing approach. These fears have two primary components.
First, that what is going through the windshield is the economy, as described by Mohamed El-Erian, former head of a major bond manager and now president of the highly prestigious Queens College Cambridge (United Kingdom), in a recent Bloomberg interview.
Higher interest rates make it more expensive for consumers to finance their purchases of houses and cars. The housing boom is already unwinding while car purchases, supported by pent-up demand, are only now starting to taper. Businesses faced with a doubling of their cost to finance expansions and new inventory will no doubt pull in their reins. The result is a slowing or reversing of previously heady economic growth.
The second potential windshield breaker is a financial accident – that a major bank, pension fund or other financial institution will collapse under fresh and larges losses that wipe out their capital. Britain’s pension system is currently on the edge of a catastrophe due to its heavy use of the formerly trendy “liability-driven investing” strategy. No one knows what hidden problems elsewhere may drive a financial vehicle into a ditch.
Such an accident could cause the financial system to seize up, forcing aggressive selling and further losses across all capital markets and participants. With memories of the Lehman Brothers debacle over a decade ago still top-of-mind for anyone over the age of 35, risk managers are pulling in their organizations’ risk tolerances – ironically increasing stress in the markets and thus threatening to spawn the very risk they hope to avoid.
As these two risks look like they are fast approaching the windshield, what can you as a private investor do today to remain engaged without enduring crushing losses?
Adopt a Value Investing Mindset
First, know where you stand. Make sure you have an up-to-date roster, with corresponding dollar amounts, of all of the individual assets you own, including cash, stocks, bonds, mutual funds, real estate and others. It’s important to include real estate, as for many private investors their home is a major component of their total assets. Both the size of this asset and the fact that it is probably increasing in value by 10% or more every year will help ease the stress produced by declines in your stocks.
Next, identify and then sell the securities that look unworthy of keeping over a 3-5 year horizon. This probably includes shares of companies that are likely to continue to produce operating losses indefinitely. Even though your Wayfair (W) stock is down 92% from its peak, the underlying company won’t likely ever be profitable. If the share price goes to zero, your loss from here isn’t another 8%, it is another 100%. And, your position sizes for these stocks are probably so tiny that removing them won’t matter to your overall returns even if they double or triple from here. It’s best to write off these stocks and move on.
Then, focus your attention, and re-investment, on companies that are solid enough to eventually prosper once the current financial and economic crunches have passed. Consider companies that operate businesses with enduring demand, that currently generate healthy profits and cash flow, and are backed by sturdy balance sheets, like Cisco Systems (CSCO) and State Street Corporation (STT). Shares of these two companies offer real value as they trade at depressed valuations yet also provide sustainable and elevated dividend yields. Thinking of these holdings as owning parts of companies, not volatile ticker symbols, will ease your stress and provide you with more mental space to hold them even if they continue to tumble in price. Remember a key tenet of value investing: the price may move around, but the underlying value is enduring.
You’ll be able to separate yourself from the stress that is consuming everyone else, and thus will allow you to capture more of the profits when the Fed eventually backs away from the brakes and the windshield is once again clear.
At the Cabot Undervalued Stocks Advisor and the Cabot Turnaround Letter, we help value 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.