The inspiration for this article comes from a combination of Howard Marks (Trades, Portfolio)' memo “There They Go Again … Again” and interactions I had with a few friends.
We all know that in the U.S, valuation is elevated, and the risk is high. But the question is what should we do now? This question is as easy as it gets, and it is also as hard as it gets – depending on many factors such as whether an investor has figured out the purpose of investing, or whether he or she has well-defined parameters (time horizon, circle of competency, etc.) in which he or she operates. Things become complicated quite easily. Regardless, in general there are few points that are applicable in today’s environment.
1. If you are an individual investor, assuming you know your circle of competency and are investing for the long term, there’s not too much difference in terms of how to invest in today’s market level versus the market level say two years ago, unless some of your holdings are trading at bubblelike valuation levels like Coca-Cola (KO, Financial) in the late 1990s or the “Nifty Fifties” in the late 1960s and early 1970s, or the tech bubble era. Over a long period of time – at least more than 10 years –Â valuation changes get smoothed out and business fundamentals dictate investment returns.
2. What you should do now depends on your opportunity cost. Your opportunity cost depends on your investment horizon and required rate of return, both of which need to be well thought out. Let’s say your investment horizon is three to five years and your required rate of return is 15%; you will essentially be comparing what you have now with what the market is offering you that may generate a three- to five-year CAGR of 15%. Because “three to five years” is relatively short, multiple change plays a key role in expected return over this period of time and at today’s valuation levels, there aren’t many companies you can be confident that the valuation levels three to five years from today will be higher than they are now.
3. Whether you should hold cash – again, this topic has been debated many times in the investment world. Holding cash implies that your opportunity set is worse than cash over a defined period of time, which may be true. But to simply hold cash because the market value seems high is almost equivalent to market timing. In a previous article, I’ve argued that the market has appeared to be expensive since probably 2013 using either the Shiller price-earnings (P/E) ratio or the Buffett Indicator (Total market cap/GDP). You have to be almost exactly right on timing; otherwise the opportunity cost is high. There are some “cash substitutes” stocks in the market – it was during last year’s Daily Journal (DJCO, Financial) meeting that Charlie Munger (Trades, Portfolio) said that Warren Buffett (Trades, Portfolio) bought ExxonMobil (XOM, Financial) as a cash substitute.
4. Amateur investors with a shorter time horizon and professional investors have to struggle with what one should do now – especially professional investors because clients pay money managers to generate returns in all types of market environments. For professional investors, I completely agree with Marks – it’s time to be very cautious and defensive. In the equity market, there are a few ways to be cautious and defensive and not necessarily in a mutually exclusive way.
- First of all, we can study the past bear markets and see how different stocks behave differently both during the late bull stages leading up to the bear market and during the bear markets. This gives us some sense of what might happen but not what will happen because things are different now. For instance, discounters like Ross Stores (ROST, Financial) and the dollar stores have done relatively well during the past two bear markets. A while ago, when Dollar General (DG, Financial), Dollar Tree (DLTR, Financial) and Ross were all punished by the market due to the “Amazon (AMZN) effect,” that was a good time to scoop them up.
- Second, there should be a focus on quality, especially quality companies in defensive sectors such as health care and consumer staples. Of course valuation matters so you have to look for quality companies trading at reasonable multiples. For instance, Allergan (AGN, Financial) and Kraft Heinz (KHC, Financial) are both high quality companies in defensive sectors (health care and consumer staples) trading at reasonable multiples. But again, you should make sure the companies fall within your circle of competency.
- Third, one can buy companies that fall under the “work-out” categories that include special situations, international stocks and companies that have low correlation with the U.S. market. For instance, if you can get comfortable with Fairfax, Prem Watsa (Trades, Portfolio) and Africa, Fairfax Africa (FFH.U, Financial) might be an interesting option – few people have heard about it; it selectively invests in Africa, about which most U.S. professional investors don’t care; and the capacity to reinvest is high as Africa’s full of opportunities and volatilities.
5. Last but absolutely not least, as I’ve stated many times, what you should do also depends on your personality type (whatever makes you sleep better). Each one of us is different in terms of our comfort level. Before you act on anything, you should remember knowing yourself is still the most important thing.
Some investors asked what I would do in this market environment personally. I manage my own personal portfolio and two other strategies professionally. In my personal portfolio, I concentrate (the five largest positions represent more than 60% of positions) quite a bit on faster compounders such as JD.com (JD, Financial). I also own a few slower compounders like Berkshire Hathaway (BRK.B, Financial) and Enstar (ESGR). The way I operate in today’s environment is exactly as Point No. 1 above. I always hold some cash because every year there are at least one or two opportunities that only last for a short period of time and I need cash to react.
In the professional strategies I manage, I follow Point No. 4 above. Even at this market level, there’s not much cash in the portfolio although there are a few cash substitute stocks. There’s less concentration (the top 10 positions are roughly 50% only). I own all kinds of companies – high growth, steady compounders, special situation, asset plays and others. Over the past year I’ve cut the proportion of high-growth companies like JD.com and Tencent (TCEHY) and allocated a much higher percentage on high quality defensive names like Allergan, Dollar General, Dollar Tree and Nestle (NSRGY). I’ve also increased the weighting of international stocks that have low correlations with the U.S. market like Fairfax Africa mentioned above.
Disclosure: Long Allergan, Berkshire Hathaway, Dollar General, Dollar Tree, Fairfax Africa, JD.com, Nestle, Tencent and ExxonMobil.
