David Thornton, who is the Editor of Growth Company Investor, did an interesting presentation for PI World this week. He made an interesting observation in that he likes to avoid stocks that are both highly valued and lowly valued, i.e. on high or low P/Es. This is very wise. The high P/Es are typically discounting a lot of future growth and show the enthusiasm by investors for the business. In reality the high valuation may be a mirage and is being driven by share price momentum and the keenness by retail investors to get on the bandwagon for small cap shares. At the other extreme, they may be lowly valued because the business has some fundamental weaknesses or big strategic problems. Growth at a Reasonable Price (GARP) may be a better investment strategy for overall long-term performance.
Terry Smith of Fundsmith has written an interesting article on market timing for the Financial Times. He is very opposed to trying to time the market and suggests that taking your money out of the market, as many people did in March, was a bad mistake. He equates it to driving while only looking in the rear-view mirror.
For an institutional fund manager, who cannot move large positions easily, that may be wise. It has certainly worked out well for the Fundsmith Equity Fund which has bounced back, and more, from its low in March.
But I am not totally convinced that it is wise for all investors. Markets do not always recover rapidly as they have done from the Covid-19 epidemic – at least so far although that story may not yet be ended. In the case of the Wall Street crash of 1929 it took 25 years to fully recover. So taking money out of the market early on might have been very wise.
Hedging your bets by taking some money off the table and hence managing your risk exposure is surely a sensible thing to do when the market is heading down. There are three things to bear in mind though:
- Small cap shares such as those on AIM can be very illiquid and hence a few sellers can drive the shares well below fundamental value. These are not the kinds of shares to dump in a market sell off unless they are directly impacted by the negative news (e.g. by the virus epidemic closing their businesses and they are at risk of going bust).
- You also need to be wary about Investment trusts. These again are often not actively traded so they can suffer not just from declining share prices in their portfolio holdings but from widening share price discounts. When the discounts get very wide, it is time to buy not sell.
- If you have moved into cash, it is very important to know when to buy back into the market. You need to keep a close eye on the direction of the market because bounces from market lows after a crash can be very rapid. Many retail investors sell at the first hint of a crash, but miss out on the recovery which is very damaging to overall portfolio performance. They miss out because they are demoralised and have lost faith in stock market investment. You do need to take a view though on whether a bounce is just emotional reaction to the realisation that the world may get back to normal, and how the recovery may affect individual stocks. In other words, you may want to move your cash back into different holdings.
As a holder of the Fundsmith Equity Fund, I would not normally argue with his investment wisdom but he may be in a different position to many retail investors. I did take some cash out of the market after the peak bull hysteria of late 2019 and in March after it was clear some companies would be badly hit by the epidemic. This provided some funds for picking up other depressed companies. But Fundsmith was not one I dumped.
The Terry Smith article is here: https://www.fundsmith.co.uk/news/article/2020/07/02/financial-times—there-are-only-two-types-of-investors
Roger Lawson (Twitter: https://twitter.com/RogerWLawson )
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