In hindsight, 2008 was a wonderful year for investors. The financial crisis had knocked share prices down on a wide range of publicly-traded companies and there were many opportunities to acquire high-quality businesses at bargain-basement prices. Of course, it was not a particularly comfortable time for those investors who had to sell shares at those bargain-basement prices in order to support their lifestyles. Almost ten years later we face a very different situation. Shares of good-quality businesses are generally trading at prices that seem to be extraordinarily high relative to their levels of profitability and growth. It is a sellers’ market and those who need cash to support their lifestyles may feel pretty comfortable while those looking to buy are feeling the discomfort.
Going forward, it is hard to see how highly-priced companies can continue to make the kind of gains they have enjoyed over the past decade. That is not to say that a major downturn is imminent (although that is a possibility) but rather that the recent level of annual gains may well moderate. Many investment commentators forecast broad stock market returns of not more than 3%- 6% per annum over the next several years. Although it may seem counter-intuitive, there is far more risk in the broad market indexes today than there was in the depths of the 2008-2009 downturn, given the much higher valuations that exist across the board in the public markets.
Keeping that in mind, let’s consider what needs to be done in order to earn a reasonable return without being exposed to considerably higher risk. First, think about what kind of risk is to be mitigated. For an investor, there are fundamentally two kinds of risk: 1) the risk that the entire stock market falls precipitously (“market risk”) and 2) the risk that the shares of a particular company drop in price without the prospect of recovery in a reasonable time (“stock-specific risk”).
The conventional way of mitigating stock-specific risk is to broadly diversify. By adding additional company shares to a portfolio the overall impact of a price drop for any one company is reduced and the stock-specific risk in the portfolio decreases. Of course, as more companies are added and the portfolio starts to look more like the overall market, the market risk increases. Mitigating market risk usually involves adding assets other than stocks to a portfolio (e.g., bonds or cash). This has the effect of trading off the potential gain that may otherwise be earned against mitigating the impact on a potential market decline. This may also add a new kind of market risk since, for example, a rise in the general level of interest rates will result in a broad drop in bond prices.
We think that a good way of approaching this risk conundrum is through conviction, concentration and cash. If we can find, even in an overpriced market, just one company that we are confident has a high probability of say, doubling in price over the next five years (a 15% average annual return would produce that result) and we have the conviction to buy enough shares to represent say, 1/15th (just over 6%) of the portfolio, that holding alone will add one percentage point to our overall expected portfolio annual return in that period. We still have the risk that the company does not do as well as expected but rather than mitigate that by broadly diversifying, we mitigate it by increasing our level of confidence and conviction through in-depth research before we buy the shares. If we could find five such opportunities, we could expect the portfolio as a whole to realize around a 5% average annual return over the next five years with only a third of the portfolio concentrated in shares and the rest left in cash or short-term bonds, to await future deployment.
By keeping the maturities for bonds short term, the risk of any rise in interest rates is mitigated. What we accomplish with this approach is an expected return at least as good as the broader markets with far less risk (remember only 1/3 had been invested), either of the stock-specific or market kind.
It would be exciting if we could identify fifteen or twenty companies that meet our criteria for quality and price. In 2008 those opportunities were plentiful and we were able to take full advantage of them. Today those opportunities are very rare but a few do exist.
When it comes to investing there is no reason or rule that states you have to be fully invested in the market all the time. If holding cash is the best risk/return option, then that is the option that should be exercised.
Even in the kind of uncertain markets we are currently experiencing, we think our approach of conviction, concentration and cash will yield a return that will more likely enable you accomplish your financial goals while exposing your capital to a lower risk of a permanent loss.