How can equity investors protect themselves against painful stock market volatility? Simon Edelsten shares eight ways.
Is it conceivable that Brexit might trigger the next bear market? It’s impossible to say. Research shows that the trigger for a bear is different every time. However, there are two consistent portents of doom: economic slowdown and excessive valuations.
The US economy is likely to slow, but there are no signs yet of recession there. Economies in the rest of the world, especially in emerging markets and China, are slowing markedly, though, probably because of US-initiated trade disputes and, in some cases, sanctions. This seems to be having a knock-on effect on German exports. So global growth is slowing, but that’s usually a recipe for a stock market correction, not a bear market.
However, Mid Wynd International Investment Trust has been concerned for some time about valuations. Here are my top eight tips for fortifying your portfolio against the worst of any downturn. Valuation considerations are the obvious starting point.
1) Don't take valuations on trust
It’s human nature to fall for hype. Disruptive technology companies are turning traditional industries on their heads, but there comes a point when people start to buy the story and disregard the numbers. Valuations run ahead of value. Have the courage to sell when that happens. You may feel a fool for a while as prices continue to rise but – as we saw in October – when a market corrects, it’s often the most overvalued stocks that fall furthest.
2) Rebalance regularly
Run your winners, but don’t let successful stocks grow so big that a single holding takes up, say, 8% of your portfolio. Doing so can leave you very exposed if that stock hits trouble. Our target limit is about 2.5%, so we are not too vulnerable to a shock fraud, a daft tweet from Donald Trump or governmental interference, which can all cause a stock to plummet. There is little excuse to be overconcentrated when the global equity market offers so many good opportunities.
3) Beware of cyclical stocks
Some businesses (such as housebuilders and travel agencies) follow cycles. Don’t become over-exposed to stocks in such firms. They force you to time the market, and that’s risky.
4) Don't ignore debt
Companies with high levels of debt are vulnerable if interest rates rise suddenly and the economy turns. High interest repayments can strangle the life out of a firm. Vet the debt in your portfolio.
5) Invest like a dragon
Watching Dragons’ Den, it’s remarkable how often entrepreneurs come forward with great ideas that can be easily copied. It’s one of the most common factors that persuade a dragon to keep their money pile intact in that little coffee table near their chair arm. Follow their lead. Look for firms that provide products and services in markets with high barriers to entry – whether they be brand power or unique technology. If inflation hits, these businesses are better equipped to raise their prices, as no one can undercut them.
6) Don't be afraid to be fickle
Scanning the components of the FTSE 100 at its launch in 1984 reveals that around three quarters of constituent companies at the time have undergone an acquisition, a merger, a takeover or a bankruptcy. Yet markets often value companies on the basis that they’ve been around for years and will be in business for years to come. Be sceptical of valuations and don’t stay in love with a stock just because it rewarded you well once.
7) Always look ahead
Henry Ford famously said: “If I had asked people what they wanted, they would have said faster horses.” It’s very easy, as an investor, to become so focused on how fast the “horses” in your portfolio are going that you fail to notice the “cars” about to overtake them. If you’re managing your own money, look ahead.
I spend a lot of time reading about technological changes that might undermine the investment themes we currently hold in our global equity portfolio or, on the positive side, might become the themes of tomorrow.
8) Stuffy stocks have their place
It’s good to be forward-thinking, but a portfolio of exciting young prospects is risky. It can pay to have a balance that includes a few old bores: businesses that may be dull but are well run by experienced management teams, and know what they’re doing and do it well. A sensible portfolio is often a boring portfolio – and it’s always diversified.
The best way to make money is to not lose it in the first place. Following these rules – and focusing on valuations in particular – won’t immunise you completely against losses, but it may mean you lose significantly less than most investors.
Simon Edelsten is manager of the Mid Wynd International Investment Trust.