Australian Shares: Keep the Faith

KEEP THE FAITH



Tony Young | 20 July 2008


Tony Young is a former head of research at Credit Suisse First Boston. Tony is now a consultant to Morningstar. The views expressed in this note are not necessarily shared by Morningstar.


This is a confusing time in stock markets. Should I buy now or sell before the market falls further? Is the market going up or down? How have I lost so much money? I thought I was investing in good stocks. What has gone wrong? How many of you have echoed these sentiments over the past six months? In this time of doom and gloom it is worth revisiting the basics of investing.


Firstly let's address the issue of what may happen in the short-term. A number of stockbrokers and commentators told us last month in June - there is a good chance of a July rally - the charts look good - stocks will bounce after the end of tax year-end selling. Stocks will bounce after the banks finish selling shares taken as security from the problem margin loan brokers. The Australian fund managers are sitting on high levels of cash and need to invest. Some commentators are telling us that we are entering a period of global recession. Others are saying that the growth out of Brazil, Russia, India and China (BRIC) will result in the markets bouncing back. Oil is going to US$200. Oil is going to US$100. Inflation is a problem and the Reserve Bank will lift interest rates. Times are tough and the Reserve Bank will reduce interest rates. When the market went up in April one broker wrote that the market had bottomed and you should now buy. Now that the ASX has fallen six weeks in a row that same broker last week wrote that we should now stay out of the market. Confusion, confusion, confusion.



Rule Number One


Short-term trading is highly uncertain and not recommended for investors. I have not yet found any forecasting tool that can be reliably used to make money from the stock market within any 6-12 month period. Yes, you can make money from short-term speculation if you are lucky but you can also make money if you are lucky enough to back the 8 to 1 winner at Dapto Dogs. Luck is a tool for speculators and gamblers, not investors. Many commentators are now espousing doom and gloom. Will they be right? I have no idea. The only certainty is that in the short-term, the market will go up, down or move sideways.


On the other hand the one certainty is that the stock market will go up over the longer term no matter when you buy. Of course we would all love to buy on the dips to maximise returns but even those people who bought the market on its high multiple one month prior to the crash in October 1987 are ahead today despite our market falling around 44% in 1987, 19% in 1990, 15% in 2002/3 and currently down 27% from its peak on November 1, 2007. In fact if you purchased the market in September 1987 you would be up 390% which works out at a return of 8% pa over almost 21 years. This leads to Rule Number Two.



Rule Number Two


The lowest risk method for investing is to buy excellent companies at attractive prices and be prepared to take a five-year view. It is impossible to predict the exact timing but the odds are great that sometime in any five-year period the market will either fairly value or possibly overvalue a stock. It is delightful when it happens sooner rather than later but sometimes you will experience short-term pain when you are sitting on short-term paper losses. One needs to understand that investing in the stock market is an emotional rollercoaster. In markets such as today's it is easy to be full of self doubt. Some look for a light at the end of the tunnel - getting excited when the market rallies for a few days, only to see it fall again. Such short-termism leads to mistakes. Keep the faith and focus on the longer term. It will get better but we are not fortune tellers and can not pin-point when this will happen. Note there is a brief discussion on the characteristics of a good business further on in this article.



Rule Number Three


Only invest monies that you can adequately finance over a five year period. It was stated previously at some point in any five-year period the market will likely fairly value or possibly overvalue a stock. It is also likely that in any five-year period markets will experience at least one crisis. In the past couple of decades we have had the 1987 crash, the Russian default crises, the US savings and loans crisis, the Asian markets crisis, the tech wreck and now the sub-prime wreck. Market problems are seen as surprises yet they are reasonably regular (again illustrating the difficulty of short-term trading). You should tailor your personal balance sheet to withstand these crises. The current sub-prime crisis will pass but you can expect another problem in financial markets sometime in the next five to six years and it can happen at any time. Do not make the assumption that once the sub-prime crisis abates the market will be totally safe for the next few years. If it is part of your strategy to borrow money to invest make sure you have sufficient reserves and cash flow to finance it through these crises.


What is a good company? There are circa 1900 companies/trusts listed on the ASX and being a small market it is difficult to find stocks in which to take a five-year investment view. There are a large number of companies that don't make the grade and people are buying and selling these stocks every single day - no wonder we have a turbulent market and one that needed a clean out after so many buoyant years.


A good business sells products or services that customers will want or need into the foreseeable future. It should offer a good return on equity, have a strong balance sheet, produce strong cash flow and be well managed. I recommend that you review your equity portfolios and for each stock ask whether it sells products or services that customers will genuinely want or need in the foreseeable future. More than 50% of the companies on the ASX fail this test. There are many companies with promises, short-term offerings and prospects but it is questionable how sustainable their business models really are. I am not saying that these are bad companies but suggesting they represent higher risk investments. With a truly good, sustainable business it is simple to understand where future earnings will come from and the risk of surprise is lower. I will use Macquarie Bank as an example. A small boutique investment bank in an isolated part of the world achieving more than 50% market share in global infrastructure financing markets is a truly amazing success story. It significantly benefited from the availability of cheap debt, low discount rates (in terms of valuing its satellites) and strong capital markets. The world has changed; is it still offering products or services that customers genuinely want or need? Are the bulk of its future earnings truly transparent or is it a black box? The new management team may successfully adapt and Macquarie Bank may continue to be a success but is it a low risk investment or is it one mostly based on faith? A good business is only a good investment if the share price is also attractive. In my view Woodside Petroleum is an example of a good, world class, well managed Australian company. LNG is a product that customers will obviously want/need for the foreseeable future and it will produce an excellent ROE for Woodside. Good companies can have short-term hiccups and it is possible that the oil/gas price will fall in the short-term. However, Woodside has huge gas reserves and it is my belief that on a ten-year view the global supply/demand forecasts for LNG mean that the long-term prices Woodside will receive for its products are not likely to fall materially from current levels and will more than likely go up.



Rule Number Four


Do not buy a share solely on the basis of yield. A number of brokers are currently recommending stocks on the basis of yield. A good yield is an added bonus but it should never be the primary reason for buying a stock. The golden rule for buying shares is still to stick to good businesses that are being offered at attractive prices. Eighteen months ago, brokers were recommending we buy Record Realty at 90 cents with its yield of 11% (one of the then highest yields in the market). The share price is now 5 cents and it is no longer paying a dividend. Unless there is a good cash producing company at the heart of an investment there is no guarantee that historic dividends can be maintained. An investment in an ordinary business with a high dividend yield can lead to a capital loss that is greater than the dividend received.



Conclusion


History has shown that you can make money following the above rules. There are currently excellent buys in the stock market but there is no guarantee of short-term gains. When is the right time to buy? Who knows! I have yet to meet anyone who can accurately predict where the market is going over the short-term. Some guess right some of the time but not all of the time. The only certainty is if you buy a good company today at an attractive price you will achieve an excellent return sometime in the next five years. Could you possibly buy better by waiting? Yes, but any attempt to finesse the purchase date is just guessing. Remember truly excellent companies are not in abundant supply in the Australian market and their prices will turn quickly once confidence returns. Other corporates will look to take over solid companies if their share prices remain low. We all know the best time to buy and sell is to go against the herd. The tidings of gloom are overwhelming at the moment and the commentators are right to be concerned. The financial system is currently in a mess. However the key question is whether these problems are already built into the prices of good companies. It takes courage to go against the herd and conviction to sit on paper losses when you are a part-owner of a good company. Stick to the golden rules of good investing and keep the faith.
 
Good read.

I like rule 2 and 3 particularly.

Makes me feel more confident about buying some NAB shares - currently at $24 and loose change, but were up around +$31 not that long ago.

Everyone seems to be scared $h!tless of Banks now. ;)

They could go further down I guess, but how far? Will watch for a bit longer.
 
Good read.

I like rule 2 and 3 particularly.

Makes me feel more confident about buying some NAB shares - currently at $24 and loose change, but were up around +$31 not that long ago.

Everyone seems to be scared $h!tless of Banks now. ;)

They could go further down I guess, but how far? Will watch for a bit longer.

i guess there's the warren buffet contrarian mentality there - be fearful when everyone is greedy, be greedy when everyone is fearful.
 
A few comments:

Short-term trading is highly uncertain and not recommended for investors. I have not yet found any forecasting tool that can be reliably used to make money from the stock market within any 6-12 month period
This is confusing short-term trading with forecasting. Successful short-term traders (and there are some) don't make money by trying to forecast what's going to go up over the next 6-12 months.

but even those people who bought the market on its high multiple one month prior to the crash in October 1987 are ahead today
And quite a few of them are also dead. Not much fun being ahead posthumously.

be prepared to take a five-year view
A bit deceptive using a 20 year period to promote a 5 year view. Those who bought the market high before Oct 1987 were still down about 37% five years later (based on the index).

However, in general I agree that for investors who are young enough, taking a long-term buy and hold view will probably give the best results. But in the current environment, take particular note of point four.

GP
 
The same rules in the article regarding shares equally apply to the property market.

Buy well, long-term outlook, ensure you can maintain it, don't get scared by fluctuations.
 
The same rules in the article regarding shares equally apply to the property market.fears
Property investors should invest on the ASX too. The same dynamics apply but the time lines are dramitacally different. A few years on the share markets equals a few decades in property. The big similarity is that you will constantly find that the market is not as smart as you are. :D
 
Property investors should invest on the ASX too. The same dynamics apply but the time lines are dramitacally different. A few years on the share markets equals a few decades in property. The big similarity is that you will constantly find that the market is not as smart as you are. :D

Yes especially when you consider the % of the market that is tied up in superannuation funds and active funds management who are churning portfolios to constantly beat the index on a monthly and six monthly view yet alone annual view.
Look how many funds managers have lost investment mandates in the recent volatility.

But all this gives the retail amature investor an edge over the professional equity managers. The professionals would be out of a job if they said 'hey foreget about my current return, my stock selection will pay hansome returns after 5 years'.
 
A few comments:


This is confusing short-term trading with forecasting. Successful short-term traders (and there are some) don't make money by trying to forecast what's going to go up over the next 6-12 months.


And quite a few of them are also dead. Not much fun being ahead posthumously.


A bit deceptive using a 20 year period to promote a 5 year view. Those who bought the market high before Oct 1987 were still down about 37% five years later (based on the index).

However, in general I agree that for investors who are young enough, taking a long-term buy and hold view will probably give the best results. But in the current environment, take particular note of point four.

GP

The great thing with investing is the removal of independent probability. If something has fallen 20% the chances of it falling another 20% is less. And if it does fall another 20% the chances of it falling another 20% are less again. (This does not mean 100% CERTAINTY of it not falling further, just the probability drops each time).
So overall if you buy something when it has fallen 20% you have more probability of it going up, than if you buy something that has just gone up 20%.
 
if you buy something when it has fallen 20% you have more probability of it going up, than if you buy something that has just gone up 20%
I don't agree. I think the highest probability over the longer term is in the direction of the primary trend over that same period. If the price has risen 20% in an uptrend, I think it has more chance of going up another 20% than down 20%, unless the trend comes to an end. Similarly, if the stock is in a downtrend, after a 20% drop I think it has more chance of dropping another 20% than rising that much again.

Buying dips in uptrends gives good results, and if a 20% drop can be considered a dip rather than a trend change then yes, the chances of it going up again are higher (since it's still in an uptrend), but the same cannot be said in a downtrend.

GP
 
i guess there's the warren buffet contrarian mentality there - be fearful when everyone is greedy, be greedy when everyone is fearful.

Chillea
why is warren buffet sitting on $42,000,000,000 cash.
Whats the urgency to get into the market.
Why are you using charts and logic when the market isnt rational,

Particularly at this point in time?
Horses for courses.

NAB dont know what they are exposed to in the subprime, according to MAX WALSH and I bet as they know more it will get worse.

The hardest thing to do in te share market is to have some patience
 
I don't agree. I think the highest probability over the longer term is in the direction of the primary trend over that same period. If the price has risen 20% in an uptrend, I think it has more chance of going up another 20% than down 20%, unless the trend comes to an end. Similarly, if the stock is in a downtrend, after a 20% drop I think it has more chance of dropping another 20% than rising that much again.

Buying dips in uptrends gives good results, and if a 20% drop can be considered a dip rather than a trend change then yes, the chances of it going up again are higher (since it's still in an uptrend), but the same cannot be said in a downtrend.

GP
With all due respect
your argument is just as good as flipping a coin.

Also at the time you wont know if it is a dip or a trend until after the event.

I would suggest ,you can only argue your viewpoint with some authority when you talk about an individual stock and look at its history , current events and conditions
 
at the time you wont know if it is a dip or a trend until after the event.
True, but there are usually multiple dips for every trend change (in a stock that has a tendency to trend), so, all other considerations aside, the probability of it being a dip is higher than it being a trend change. And we're only talking probabilities here.

I would suggest ,you can only argue your viewpoint with some authority when you talk about an individual stock and look at its history , current events and conditions
The comment was related to individual stocks, and the stock's history would need to be considered to identify its trending behaviour for a start.

Consideration of current conditions is debatable though. In all conditions there tends to be both strong bullish and bearish arguments put forward (just look at how much debate there is right now about whether the market is at a bottom or not), and current events and conditions show up in price action. If the news is all bad, the stock won't be trending up, so you could say that by investing with the trend, you essentially are considering current conditions (or rather, the market is doing it for you).

GP
 
With all due respect
your argument is just as good as flipping a coin.

Also at the time you wont know if it is a dip or a trend until after the event.


nothing wrong with flipping a coin as long as the payout on the win is greater than 1:1.

ide be happy to roll a die all day long for 7:1, no i wont know wheather i am right or wrong until after the event but do i really need to??
 
LOL - okay, I mean "normally" when I used to work in the gaming industry. Obviously their terminology was a little different at the time, including the return of the bet in the first figure.

GP
 
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