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31 May 2019

FOUNDATIONS FOR LONG-TERM INVESTMENT GROWTH

As we near the end of possibly the longest equity bull market in history, major US markets suffered their worst December since 1931. Investors who re-positioned portfolios for this correction were wrongfooted when markets recovered sharply this year (the major US indices staged their best annual start since 1987). BRIAN ARCESE explains the critieria required to weather volatile markets.

Professional, fundamental investors exploit increased volatility and market dislocations to buy high quality companies at attractive valuations. But volatility can alarm retail investors. The unending flow of financial headlines — rising populism, Brexit/no Brexit, US/China trade wars, increased geopolitical tensions — can leave retail investors fearful and ready to sell. Unfortunately, retail investors too often divest at the market cycle’s bottom, locking in much of the downside while missing a later market rebound. 

 

So how can investors weather volatile markets? Six fundamental portfolio construction practices help to withstand volatile markets and grow investment portfolios. These pillars focus on identifying high-quality, cash generative companies with sustainable earnings growth prospects and superior management teams. Because share prices track earnings growth over time, these criteria provide a solid foundation for long-term investment growth. 

 

Focus on earnings per share. The earnings per share (EPS) ratio reflects the company’s profits on a per share basis. Because dividends are declared out of earnings, EPS indicates the company’s dividend potential. Over time, dividends account for a significant portion of the total shareholder returns. A consistently growing EPS is therefore a good primary indicator of a firm’s soundness and stability.

 

Sustainable, competitive advantages matter. Quality businesses enjoy a sustainable competitive advantage and strong franchise value. They exhibit steady earnings growth and a durable business model. An obsessive focus on value proposition and cost control allows such companies to generate higher revenue at greater profitability than peers, leading to correspondingly better return on capital.  

 

Strong balance sheets and cash generation support survival and expansion. Companies that generate strong, free cash flows, the lifeblood of any business, to internally fund growth are attractive. In contrast, poor management teams don’t appreciate the value of cash generation until they need it but don’t have it. Strong balance sheets and cash flow generation are essential in lean times, for ongoing investment, business expansion and for paying dividends.

 

There is no substitute for excellent management. The competence and quality of the management team are paramount to the company’s culture, strategy and success. Even companies with excellent products can be mismanaged. A winning management team displays superior capital allocation skills and fiscal discipline by not overinvesting during periods of economic strength or underinvesting during periods of economic weakness. The team’s economic interests are typically well aligned with those of shareholders.

 

Valuation — buy at the right price. Superior returns come from buying good companies at reasonable valuations. A company’s valuation can be compared to peers and to the market using the price-to-earnings (PE) ratio. The PE is a simple valuation metric calculated by dividing a share’s price by its EPS. While high quality firms do not typically trade at discounted PEs, it is nevertheless important to not overpay for an investment. An overpriced asset can materially reduce long-term returns.

 

Exit a losing investment quickly. All investors, including professionals, make mistakes. But successful investors usually admit their mistakes early, exit those positions and replace them with even better prospects. Don’t panic if a share you own declines. Instead, review these investment criteria to assess if something has materially changed — the entry of a new competitor may have eroded the firm’s competitive advantage or a management team may have made an atypically insensible decision that does not create long-term value. In these instances, investors should consider divesting, even if it is at a loss, to seek better investment opportunities to redeploy capital.

 

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