Turning off the stockmarket noise

Don’t buy on market rumours … go with the companies with sound growth prospects.

Summary: Trying to predict the market is a losing battle. A winning strategy should be focused on businesses with strong long-term growth fundamentals and sustainable competitive advantages.

Key take-out: To take advantage of market highs and lows, it’s important to understand business economics and how to estimate value.
Key beneficiaries: General investors. Category: Growth.

About a month ago I sold out of more than 20% of my portfolio because the prices of the companies I owned surged past my estimates of even the most optimistic intrinsic values.

At my last four weekly investment committee meetings I have walked away with virtually nothing new to buy to replace those things that were sold. As a result, the cash has been building and stood at 36% of the portfolio last week.

Did I predict this latest market sell-off? No. Can I predict such events? No. Does sensible investing help to preserve and grow the funds you have spent a lifetime accumulating in your self-managed super fund? Yes. Can you do what I do? Yes.

The simple fact is that you must turn the stockmarket off and instead focus on businesses. Do this and you can achieve equally satisfactory returns over the very long run.

Last week gold fell 6.25% from $US1573.64 on April 8. Then, on Monday, it promptly declined 10%. Plunging gold was joined by declining prices for silver, base metals and oil too.

According to many commentators, the reason for the fall was institutional investors fleeing bullion in favour of other safe-haven assets amid concerns about central bank sales and souring sentiment.

Imagine investing by trying to predict changes in sentiment?

Eighty years ago Ben Graham, the intellectual dean of Wall Street, observed, “speculation is largely a matter of A trying to decide what B,C and D are likely to think – with B,C and D trying to do the same”.

If you aren’t losing money, you’re panicking or at least scratching your head. Ben Graham was right when he described the market as manic-depressive because, in the short run, it certainly isn’t efficient.

Now, we are told there is a slowdown in the US economy and this is why we have seen a sharp sell-off in commodities. And the reason for the fears of a slowdown in the US? It’s because China is slowing!

Notwithstanding the fact that China would eventually have to be renamed ‘Earth’ if it continued to grow at 12.5% per annum, we all have known for several years that China would eventually slow the rate at which it was expanding.

One of my overpaid genius US peers was quoted: “We’re due for choppiness, given the run we’ve had,” adding, “We’re moving at a slower pace, and those who got overly excited about GDP growth are probably pulling in their horns a bit.”

Imagine investing by trying to predict when horns would be pulled back?

Markets never go up or down in a nice straight line so, for once and for all, throw out that notion and zip up your wallet whenever a so-called expert predicts it.

No sooner has the market gone down, because China is “only” growing at 7%, then it will rise because 7% growth means that interest rates won’t be hiked or because of some other equally unpredictable change in the way market participants view things.

Instead, you simply need to think about businesses.

A good portfolio is one built by selectively acquiring, at rational prices, over a lifetime, those businesses whose earnings profile ensures the business will be much larger in the future than it is today.

A better portfolio is one where those same businesses also harbour sustainable competitive advantages. The most valuable is an ability to raise the price of the product or service it sells, even in the face of excess capacity.

And the very best portfolios are the ones that have removed those businesses with the worst economics. The worst are those businesses that must do the reverse – lower prices in the face of excess capacity. Producers of iron ore and other commodities rank among the worst kinds of businesses to own because their customers do not run across the road to pay more for the dirt they sell. Their customers simply go around looking for the cheapest price, forcing the vendor to match the lowest rate going. A price taker must by necessity follow the cycles that are experienced by the commodities they sell.

So zip up your wallet if a fund manager comes, calling himself or herself a value investor, and owns such companies.

There are only two things you need to know to take advantage of market highs and lows, and see them for exactly what they are. The first is to understand business economics, and the second is to understand how to estimate value.

Do these two rational things consistently and you will discover Cyprus, China and Japan, and anything else that flies like a black swan from left field, can be used to your advantage rather than being something to run in fear from.


Roger Montgomery is the founder of The Montgomery Fund. To invest, visit www.montinvest.com

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