“You can’t predict. You can prepare.” Howard Marks
It’s easy for investors to be complacent about risk when equity markets are strong. Numerous recent company downgrades amidst a nervous market have reinforced the need for investors to prioritise capital protection. This article is guided by the words of Howard Marks, Co-Chairman of Oaktree Capital Management to explore how to think about capital protection. While it is near impossible to never lose any money, there are ways to limit the risk of permanent capital loss.
“Investment risk comes primarily from too-high prices, and too-high prices often come from excessive optimism and inadequate skepticism and risk aversion.” Howard Marks
Watch out for over-optimistic and expanding company valuation multiples when fundamentals remain the same. It may be a signal that the market is paying too much. Stocks trading on high multiples tend to price in optimistic future business conditions and growth expectations. Whilst, at times, high multiple valuations can be justified, this may become an issue when the market gets overly exuberant. At some point in time a correction is likely to occur.
There are generally two ways high multiple stocks can de-rate:
1. The multiple the market is willing to pay suddenly falls
When equity markets are driven by emotion, sharp corrections can become more likely as the market in aggregate becomes more expensive. Sentiment can quickly move away from exuberance to a state of fear, often driven by macroeconomic uncertainty. A lot of heat was taken out of the market during the final quarter of 2018, with the S&P/ASX300 market multiple dropping 10% from trading on about 16x to 14.5x. In these times, higher multiple stocks tend to de-rate more than lower multiple stocks as expectations taper. As a broad example, the S&P/ASX200 Information Technology index multiple fell 15% from 34x to 29x over the December quarter, de-rating 50% more than the wider market.
2. Underlying earnings of the business are lower than the market expects
Here both the multiple on which the company is valued as well as the underlying earnings per share of that company can take a hit. Take Costa Group (ASX:CGC) as an example. Until recently, this agricultural business was optimistically trading on a 28x forward PE multiple. Costa is now trading roughly 30% lower on 20x since announcing earnings next year would be flat. So most of the 40% fall in share price on the day of the announcement was attributed to a multiple de-rate, rather than a change in earnings. In this case a circa 10% fall in EPS equaled a 4x larger fall in the company’s share price.
The risk in owning high PE stocks is that the multiple can fall much faster than earnings, and faster than the overall market.
“People who think it can be easy overlook substantial nuance and complexity.” Howard Marks
Whilst a multiple de-rate might cause some pain, on the other hand, there is no guarantee that buying a cheap stock will protect the downside either.
If a stock is trading like there is something bad going on, it may well be. It may be the industry conditions it operates in are poor. It is worth understanding why a stock is cheap before thinking it’s a bargain.
An example of this is iSentia (ASX:ISD), a media monitoring business that once had near-monopoly status and sticky clients. It now faces headwinds from competition and difficulty keeping up with a changing digital age, among other things. Prior to August 2018, ISD was trading on a 10x multiple, yet after downgrading during the same month, the stock lost 65% of its value going from $0.80 to $0.28. An already-cheap multiple became even cheaper, down to 6.6x. A low multiple can mean that the earnings base is actually much lower than expected.
“Most things prove to be cyclical.” Howard Marks
Whether from intensifying competition, waning demand or some other structural headwind, a stock’s earnings may be at risk and investors should accept some movement to the downside or reposition the portfolio accordingly.
Industry headwinds can lead to cyclical recovery situations, but they can also be a source of downside risk. In the current environment of banks tightening their belts and weakness in consumer sentiment, some sectors may be better to avoid in the near term, including banking, property, automotive, aged care, retail and construction.
An example is Japara Healthcare (ASX:JHC), a quality aged care provider with strong return on capital and significant property assets. The announcement of the impending Royal Commission into Aged Care presented a reputational, and potentially, demand-damaging industry headwind that will not abate anytime soon. Since the announcement, the stock has drifted down an additional 17% even before the proceedings commenced.
Companies operating in tough industry conditions can do everything in their power to get ahead but some things are just out of management’s control.
“I believe in many cases, the avoidance of losses and terrible years are more easily achieved than repeated greatness, and thus risk control is more likely to create a solid foundation for a superior long-term track record.” Howard Marks
It can be comforting for an investor to identify downside risk in a stock valuation. In times of market downturn, this can help to avoid severe losses.
One example is Elders (ASX:ELD) which has deep-seated relationships in the Australian agricultural market, and a wide and expanding presence across rural regions. It gives them inherent strategic value. Another is Macquarie Telecom (ASX:MAQ), which has a large amount of earnings security through well-serviced government contracts, which become increasingly sticky over time. Adelaide Brighton’s (ASX:ABC) market position and assets are near impossible to replicate from scratch.
Whether it is strategic value, a tangible asset like property, or a high level of earnings security, these traits in companies can provide a level of protection during a downturn.
In conclusion, whilst there are no hard and fast rules or guarantees for avoiding losses, we believe these lessons provide a useful starting point when analysing risk. They help to identify companies that will endure and even benefit through times of economic decline, and ultimately reduce the possibility of permanent capital loss.
Rachel Folder is an Investment Analyst at NAOS Asset Management, a sponsor of Cuffelinks. This material is provided for general information only and must not be construed as investment advice. It does not take into account the investment objectives of any particular investor. Before making an investment decision, investors should consider obtaining professional investment advice.
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