Stay calm in a market storm

The current sell-off is a good opportunity to buy strong growth stocks at a discount to value.

PORTFOLIO POINT: During times of market turmoil, it’s important to resist following the crowd and stay focused on the inherent strength of select businesses.

This week’s market turmoil certainly should focus investors’ minds on the macro economic landscape. How important is the Greek situation for the Australian economy and our equity market? If commodity prices continue to fall, is this already factored into stock prices?

These are important questions in determining whether we should allocate capital to the equity market, and especially my model growth portfolio. In particular, is this an opportunity to invest or is it a trap for investors?

At the outset, I have a question to ask and it is this – why has there been so little investigation, and indeed explanation, as to how the developed world governments became so indebted so quickly? Greece may be a focus at present, but large levels of debt reside across governments in Europe, Asia and the US. Just maybe, if we can explain the reasons as to why this has occurred, then we will find the solutions to fix it. In doing so, we will observe that the true culprits who helped create the problem are still operating and actively engaged in preventing a proper exposure of their activities.

Of some concern is that in recent times, the world’s political leaders, their advisers and bureaucrats appear to be continually incoherent in their economic strategy. Further, their public posturing (i.e. that Europe will not undertake quantitative easing) is not always supported by their subsequent actions. Indeed, many of the policies that have been adopted seem focused on ensuring that their banking systems do not implode.

While these policies may seem overly bank-friendly, they are the right strategies for two reasons:

1. The creation and substantial increase in debt in the economic system required financial intermediation. The major intermediaries are the banks. Right now in Europe, the major concern is the solvency of banks, given their substantial exposures to subprime sovereign debt and asset bubbles in individual economies. This solvency therefore requires constant attention by the European Central Bank. It also means that the banks themselves continually undertake activities to hedge themselves against a possible calamity. That hedging can and will disrupt markets.

2. The US Federal Reserve (guided by Ben Bernanke) realised in 2008 that in order to avoid a calamitous recession, it had to undertake massive intervention and support for the US banking system. Quite simply, the Fed realised that in a recession people are happy to leave their money in a bank, however a recession becomes a depression when people cannot get their money out! The Fed ensured that US citizens did not lose confidence in US banks.

I believe that the major financial intermediaries of the world lost their integrity long before 2007. This was caused by an unrestrained focus on short-term profit, the negligent non-enforcement of long-established credit rules and the lack of financial regulation as governments embraced free market theory. The result has been a substantial increase in the sovereign debt of many countries, as governments bail out banks and their destabilised economic systems.

While we are now presented with a mess, history suggests that we would be quite foolish to believe that these problems will be left unresolved. Indeed, the resolution will ultimately come from the recognition that financial intermediaries need to be strongly regulated. That view then takes us to the crux of the current market. At this point, the only banks that are close to being regulated are those that have fallen into government ownership through their own incompetence. The full or part nationalisation of banks is occurring at a constant rate – observe Iceland, Ireland, the United Kingdom, now Spain and soon Greece. Is this a bad thing or a logical consequence of a financial system that did not observe one basic rule to only provide credit to those that can pay it back?

Thus in Europe, banks will attempt to avoid regulation – and possibly nationalisation – by undertaking hedging activities to insure against a calamity such as an uncontrolled default by Greece. At this point, there are many other market participants who are also hedging their exposures, but the European banks must be aggressive and they are doing so across many markets. The Australian market and indeed our major companies are being used as just another way to hedge the precarious position of many financial intermediaries in Europe. The 2% fall in the Australian market on Wednesday is a symptom of hedging activity rather than a true reflection of our outlook.

If Greece did default and collapse (and I actually doubt that it will just yet), then many more European banks will fall into government hands. Those governments will transfer bad debts to central banks and recapitalise their banks via quantitative easing on a massive scale. Is that actually good or bad? Those banks will continue to open for business and people will not panic. If it is bad, then who do you think it is bad for? The governments of major European countries will support their major banks because that is what governments do, but the executives of those banks will face severe sanctions.

Conclusion

When markets gyrate as they have done this week, we must question whether we actually understand why it is happening.

During the last four years, there have been times of manic behaviour in the market analogous to mob rule. During these periods many investors forgot the logic of investing by comparing value to price. It is much more comfortable to stay in the pack as it lurches between pessimism and optimism. By doing so, the opportunity to acquire good growth companies at good value is lost.

Indeed, when managing investment funds for clients at Clime, we do so by acknowledging the current economic environment and then drawing logical conclusions about the future. I would suggest that many market participants consistently fail to observe, acknowledge or even think about how central banks, governments and markets will ultimately respond to changing circumstances.

An example is the recent significant fall in the price of major mining shares; they are solidly in my long-term growth portfolio. The recent share price falls have as much to do with the hedging activities emanating from Europe as the chatter about commodity prices. Investors need to be aware of what is likely to happen if indeed commodity prices and Australia’s terms of trade do continue to decline. That is, the Australian dollar will also decline and this will offset the price falls to a significant extent. Commodity price declines will not always lead to lower profits and profitability for major miners. This point is particularly important to note when volumes are increasing.

My advice is as follows: do not follow the mob and do not question the inherent strength of good Australian companies, many of which are in my growth portfolio. Price movements often do not reflect the underlying business strength of companies. This correction is an opportunity to acquire a few more shares across the growth portfolio. My portfolio of companies is now being offered in the market at a greater discount to its value than a short week ago. That alone is good news.

-Clime Model Growth Portfolio (prices as at May 17, 2012)
Company
Code
Purchase Price
Market Price
June 2012 Value
Safety
Margin
GU Yield
Total Return
BHP Billiton
BHP
35.5
32.77
54.63
66.71%
4.49%
-7.69%
Commonwealth Bank
CBA
50.78
51.02
58.94
15.52%
8.85%
0.47%
Westpac
WBC
22.02
21.22
27.57
29.92%
10.03%
-3.63%
Blackmores
BKL
27.55
26.2
28.33
8.13%
0.60%
-4.90%
Woolworths
WOW
25.85
26.94
31.53
17.04%
6.42%
4.22%
Iress
IRE
6.75
6.2
7.28
17.42%
8.37%
-8.15%
The Reject Shop
TRS
12.04
10.48
14.51
38.45%
4.23%
-12.96%
Brickworks
BKW
10.45
10.07
12.33
22.44%
5.82%
-3.64%
McMillan Shakespeare
MMS
11.01
10.24
11.42
11.52%
5.16%
-6.99%
Mineral Resources
MIN
11.77
10.38
14
34.87%
5.64%
-11.81%
Rio Tinto
RIO
66.6
58.16
84.06
44.53%
2.92%
-12.67%
OrotonGroup
ORL
8.64
8.14
9.48
16.46%
8.78%
-5.79%
 
* Market prices as at close May 17, 2012

One last thing – Commonwealth Bank of Australia (CBA) reported a further increase in cash profit for the March quarter. Surely that does not sound like a calamity in Australia? My valuation of CBA follows the portfolio below.

Source: MyClime

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