Share markets can drift seemingly higher and higher without a hitch for many years, then one day due to sudden turbulence, markets will often ‘pop’ and correct. How can an investor be prepared for such unforeseen events?

Long term investors learn from experience that stock market sell offs happen on a fairly regular basis. These corrections, crashes or bear markets – as the media often likes to refer to them – are an unfortunate, but inevitable part of every stock market cycle.

Corrections in the share markets are a self-cleansing mechanism which occur to rid the markets of the speculative excesses built up as markets rise to new highs.

One can never accurately predict the timing of such corrections although many similar symptoms often exist before a correction occurs – such as high stock valuations, increased speculative activity in poor quality companies and general investor apathy.

What steps can investors take to be prepared for such ‘unexpected’ and often painful events?

1. Hold good quality stocks in your portfolio and understand where the company is aiming to be in the next 3 to 5 years

When corrections occur, you should always try to keep a level head. This is often not easy as the news headlines are full of dire headings and all sorts of ‘experts’ seem to come out of the woodwork with predictions of doom when share markets are falling.

As a long-term investor, if your portfolio consists of quality companies then you should remain comfortable with your holdings when a correction occurs. In fact, as a long-term investor you may even look to use any severe market weakness to buy more shares in the quality companies already held in your portfolio. Should prices become cheap enough, you may even use market weakness to invest in new quality companies that are now trading at a reasonable price.

Being invested in quality stocks means a long-term investor can ride out the storm and as the legendary Warren Buffet says:

“be fearful when others are greedy and to be greedy only when others are fearful.”

As mentioned earlier, share market corrections are a self-cleansing period in which speculative excesses of lengthy rising markets are cleaned out – thus in the 1987 stock market crash, it was the previously high-flying entrepreneurial companies such as Bond Corp and Bell Group that were the worst hit when the market crashed. In the share market correction of 2001 when the US Nasdaq collapsed, here in Australia we saw previously high-flying companies caught up in the internet boom of the time such as Onate, Davante and Escarp which were worst hit. Similarly, in the GFC-era stock market crash of 2008-2009 it was highly geared companies like Babcock and Brown, ABC Learning and Centro that were worst hit. Most of the companies mentioned above never recovered, either collapsing or trading at fractions of their boom-time share prices.

Another of Warren Buffet’s quotes which is very relevant at times of a share market correction:

“you only find out who is swimming naked when the tide goes out.”

In other words, it is often during and following market corrections when good quality companies stand out, when compared with many of the speculative ones which only looked successful because of a long running rising share market when investors were willing to buy and back risky, low quality companies with very little substance.

2. Investors should always hold a diversified portfolio of quality assets

Long term investors understand that all assets – shares, property or cash – go through periods where they are in favor and out of favor. To lessen the volatility of returns, investor should hold a diversified portfolio of assets across asset classes. The percentage held in each asset class depends on each individual investor’s risk tolerance and investment objectives.

Within equities, at IML we have always had a preference towards holding a diverse array of quality industrial companies. This diversity ensures that the portfolio is not reliant on one or two stocks, or on one sector (e.g. banks). A diversified portfolio can help mitigate the impact of a downturn in one pocket of the economy as different companies have different drivers and underlying exposures to the economy. As an example, whilst a bank may suffer from a downturn in credit creation or an increase in bad debts, such an event in the economy will have a more modest impact on Consumer Staple stocks such as supermarkets or Healthcare companies such as CSL.

In addition, in our opinion it is always advisable that the assets held generate a reasonable, sustainable income for the investor so that the portfolio can continue to generate an income return for the investor when asset prices are subdued.

Other tips on coping with share market corrections

Over the last 20-30 years we have observed that in the initial stages of a correction in share markets, it is not uncommon for almost every stock to fall as many investors rush to reduce their exposure to share markets. It is thus very common to see indiscriminate selling across the market when corrections occur – what we refer to as the good, the bad and the ugly all sold-off in the initial stages of a correction.

However, when the panic subsides and sanity prevails – which inevitably happens – good quality companies with strong underlying businesses, and with real earnings always recover well.

Corrections are a natural part of all share market cycles. The best protection for long-term investors in all price downturns is to be invested in a diverse range of high quality, income producing assets; to stay calm and to see if the opportunity emerges to add good quality assets at depressed prices.

Anton Taliaferro, IML Investment Director
 
To mark the 20th anniversary of quality and value investing at Investors Mutual’s, Anton Taliaferro has developed 20 lessons from 20 years. You can subscribe at iml.com.au/20-lessons