Keeping a cool head

Tuesday, 16th February 2016 14:05 - by David Harbage

Equity markets have been particularly volatile since the writer's last blog, which sought to highlight some domestic rays of light in an article entitled, 'Amongst the gloom....' Over the intervening month, the FTSE100 index has swung from 5,779 up to 6084 on 29 January, before plunging to 5537 on 11 February and recovering to 5,824  at the close of business today.

If you are a trader, such double digit percentage change can be a potential delight or disaster. To investors with a long term perspective, 10% capital movement matters little. Which is not to say that one should not be mindful of any significant alteration in global macro-economic fundamentals. Looking behind the apparent, often media-induced, 'noise' surrounding sharp movements in stock markets for new news or causes of panic is often difficult.
A number of the prevailing issues have previously been highlighted in this blog: a slowdown in China's economy and appetite for commodities, central bankers' limited firepower to address any fragility in the world's financial structure, economic flat spot, consumer debt or deflation. Major oil producing countries are struggling to adapt to the collapse in crude prices, and their sovereign wealth investment funds have no doubt been forced sellers of liquid assets - including equities. Rising geo-political tensions in the Middle East have not helped appetite for risk and significant reinvestment into cash and 'gilt-edged' government stocks (despite paltry yields on offer) has been evident.

Beyond ranking such contributory factors for the disappointing performance of equity in 2016 to date, a number of market strategists have referred to the prospect of a major, rare, unknown or unpredictable risk event occurring. Sometimes described as the 'black swan' theory, by reference to Nassim Taleb's book of that name published in 2007 which highlighted particular historical events or scientific discoveries - such as World War 1, the breakup of the Soviet bloc, the September 11 2001 tragedy, the personal computer and the Internet - as being unanticipated, world changing events. Prior to its discovery, the existence of a swan with anything but white feathers had never been entertained and, being viewed as an impossibility, the expression 'black swan' was coined in medieval times. Taleb had previously published a book in 2001 entitled 'Fooled by Randomness' on financial markets and events, which similarly discussed the prospect of an unanticipated event having an extreme, high profile impact on the financial infrastructure or market.

To some extent, it could be said that commentators would only reach for the black swan theory when they run out of rational reasons for market behaviour and resort to 'gut instinct' rather than logical explanation. The reality is that the equity market does tend to be illogical and random at times, driven as it is by both the weight of money (net buying or selling) as well as relative valuation (compared to other assets) and 'bottom up' news flow surrounding earnings and dividends from its constituent businesses. No shame should be attached to the observer who makes the honest judgement that he or she cannot account for why the market has performed as it has.

When risk aversion increases, be it justified or unexplained, cautious investors can respond by 'raising the bar' insofar as their ongoing ownership of individual company stocks is concerned. While major turbulence in a stock market can be indiscriminate - especially when many commentators and fund managers are honestly admitting that they do not understand what is causing the fear - investors can gain confidence from reassessing their own exposures. In particular, by considering the health & visibility of the industry and the business model of each company stock they hold. Owning firms which are profitable and strongly cash generative (that is, there is a high conversion rate of earnings into cash receipts) will naturally lead to a healthy, lowly financially geared, balance sheet. Which in turn might be the catalyst for an additional return of cash to shareholders.  Understanding how a business makes its profits, the factors that influence demand for its product, the nature and magnitude of its costs and an investigation of profit margins throughout an industry cycle will all help to determine if an investment represents a high quality (visible and understandable, with a sustainable market leading, if not growth) business which can be retained - or, alternatively, should be jettisoned - in the current clime. 

Having been convinced of the company's merit and its future prospects, the cautious investor will want to ensure that the equity valuation is reasonable compared to its peers and the wider universe of the stock market. This can be assessed via various means, but consideration of the long term growth rate relative to its current worth - using mathematical formulae such as discounting or converting estimated future cash flows into a present day value - is key. This extends the use of the PEG ratio, which compares the forecast growth in earnings to the current PE (consider current share price and historic or future earnings per share), beyond the two or three years' projected earnings.

Such methodology can support ownership of apparently expensive businesses, such as Reckitt Benckiser who announced strong trading results today, because the market is taking the view that this health & household product multinational will maintain its leading position in its industry and will continue to produce decent growth over the next decade, and beyond. Based on projected earnings per share of 257.7p in the current calendar year, RB stock is priced on an earnings multiple of almost 25 times which puts it in the top ten percentile ranking of the FTSE100 index's constituents. Seemingly very fully valued, after today's 6.8% hike in the share price, this could prompt the more aggressive (shorter term oriented) investing institutions to book some profit. Others, perhaps looking out to a more distant horizon, will believe that Reckitt's better than expected numbers for 2015 - and demanding targets for revenue and operating margin growth in the current year - justifies retention.  

Ultimately, history has shown that earnings or profit growth has translated into progress in equity worth (at a not dissimilar pace). Looking back over the past 70 years, UK equity has delivered positive returns in 84% of every five year period and 96% of every ten year period. The prospect of taking a longer term stake in profitable businesses (mindful that under performers or relative losers tend to slide out of indices, as they are replaced by more successful companies) has real, inflation-beating appeal. 

Having said that, we probably live in a more dangerous world (post 9/11) with a less robust financial system than could have been envisaged before the banking crisis of 2008. A slower pace of growth, both global and domestic, must be anticipated for at least another 5-10 years. Politicians rarely inspire and central bankers often appear impotent. Changes in the environment and less predictable weather appears to be a 'given', while ever faster technological development in medicine and IT/electronics provides opportunity. No black swan event on the horizon, but enough concern to ward off any investor complacency.

For this investor, committed to reinvestment of dividend income for the foreseeable future, recent market weakness represents an opportunity to buy equity at lower, more attractive prices. Uncertainty abounds (and will continue to do so), making a regular review of one's asset allocation - accompanied by an investigation into the nature and magnitude of risks faced by individual company investments - essential. If in doubt, investors should err on the side of caution (ensure you can sleep at night) by increasing the quality of their portfolio and reducing exposure to highly valued companies.

Written by David Harbage for lse.co.uk on the 16th February 2016

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.