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Steven Chen
Steven Chen
Articles (206)  | Author's Website |

Why Every Intelligent Investor Should Applaud the Selloff

A basic explanation

During the market turmoil in February 2018, I briefed my following recommendation to "average" equity investors who were having trouble sleeping due to investment-related anxiety:

"1. Consistently buy a low-cost broad stock market index fund, such as the S&P 500 ETF (SPY), no matter what happens in the market;

2. Never be panic selling;

3. Don't even think about market timing or stock picking;

4. Avoid handling equity investment by yourself in case 1, 2, or 3 cannot be achieved."

Fast forward to today, and those who have done these simple steps (the first three in particular) without even looking at the market or any company's financials for a single minute have not only survived but also thrived compared to those panic sellers or overconfident market-timers. Over the past two years, anxiety did revisit the stock market from time to time, including the biggest selloff since the financial crisis last week.

As you may have expected, my recommendation always remains intact for the "average," no matter what happens to the market or economy. At the same time, when it comes to more enterprising investors who try to be extra intelligent, I would like to point to the interesting fact that so few of them applaud the selloff and, more importantly, the reasons why they actually should.

Indeed, the most obvious one is that businesses are getting cheaper. The value of the stock equals the present value of all cash flows out of the company to owners from now until judgment day. Any one-off events should have limited impacts on this valuation equation unless they are "truly" different (think about the stock market that has undergone two World Wars, the Great Depression and so forth). However, even if people believe in an extreme-case scenario – whether it be a permanent impairment to human civilization or an approaching judgment day – they would not bother with accumulative monetary wealth anyways.

A mental trick in dealing with a volatile market is to pay more attention to the aggregate free cash flow that would be generated out of your shares in the businesses than to the market price of those shares. Ask yourself how companies like MasterCard (NYSE:MA) and Visa (NYSE:V) could lose 15% of their future earnings power forever within a week, without the help from those extreme-case scenarios. Shouldn't it be fair to assume their "winning war" against the cash (which represents roughly three-quarters of world's total transactions) to continue for the long run? And would the target customer base for Hermes (XPAR:RMS), Johnnie Walker parent company Diageo (LSE:DGE) or Jack Daniel's maker Brown-Forman (NYSE:BF.A) (NYSE:BF.B) shrink by more than 10% all of a sudden? By the way, all these iconic brands have existed for over a century (take your time to count the crisis moments here).

Despite Mr. Market's emotion, I can only expect these high-quality businesses to continue executing their strategies that have proven successful in their respective domains, defeat competitions through their "unfair" advantages, and reinvesting 50%-80% of their free cash flow to earn high (if not higher) returns.

I can imagine that some naysayers would argue that a plunging market is not something to worry about, but nor is it something to applaud if you do not have the cash to buy. This is, at best, partially true as it neglects the cash reserve that the business holds on behalf of its owners. That is, companies can buy back stocks more cheaply now, retire more outstanding shares and, therefore, give current shareholders the extra percentage of ownership for free. Of course, some businesses may opt for their targeted deals at a lower cost, which could translate into higher returns for shareholders, though I typically do not favor an acquisition-driven growth strategy. Remember that most deals "failed" since they were too expensive in the first place.

If you have been able to follow me so far, then congratulations! But beware that a lower price is by no means the only factor that businesses can leverage to create shareholder value and that intelligent investors can applaud – it is arguably not even the primary one if an economic hardship does actually occur. There is a potential benefit of more significance that a company can deliver to its long-term owners – a widening moat while challenging market conditions to wipe out the weaker competitors. Take a look at Graco (NYSE:GGG) – the highly-cyclical industrial business still managed to earn a 10% return on assets throughout the financial crisis, while its peers struggled with breaking even.

As a result, the manufacturer of fluid handling systems decided to spend even more on its research and development to steal market share, solidify its market-leading position, and fuel sustainable growth for the long run. What should its owners expect as the share price was cut in more than half in 2008? Nothing but a significant increase in the value of the business.

By now, you may have heard some other naysayers say: "Fair enough in these cases, but what if your business does not have any competitive edge to enhance? What if it just happens to struggle with debt burden and cash generation during the tough time? What if it is led by poor stewardship that is not wise enough to ignore the short-term noise and focus on the long term? What if it is simply not the market leader, and hence, likely to be wiped out by the upcoming recession? Shouldn't you be panic selling?" Well, the answer may be yes. Nevertheless, I think that the real question here is why they invested in these businesses in the first place, as intelligent investors should only focus on quality names.

Last but not least, let me tackle two more myths that appear to justify panic selling into high market volatility:

First, sell now and buy back when the market bottoms. Even Warren Buffett (Trades, Portfolio) does not know anyone (including himself) who can predict Mr. Market's short-term moves. In addition, Terry Smith often categorizes investors into two groups – those who cannot time the market and those who do not know that they cannot. I can see how the former group of investors has quite a competitive advantage over the latter.

Secondly, retirees would also definitely suffer a loss if they do not sell now and the market keeps going down. Stocks are for the long run. Anyone who buys and sells shares for short-term gains is not even the "average investor" (not to mention the intelligent investor) in my dictionary – let's call them speculators (or gamblers).

Disclosure: The mention of any security in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market. We own shares of MasterCard and Hermes.

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About the author:

Steven Chen
Steven CHEN is a quality-focused, business-perspective investor (with bottom-up opportunistic approaches), an ex-hedge fund analyst on Wall Street, a serial entrepreneur, computer scientist, and free-market capitalist.

Steven is the Managing Partner of Urbem Partnership, a value/quality-focused investment partnership fund (www.urbem.capital).

Steven can be reached at [email protected], LinkedIn, or WeChat (ID: LSCHEN2005).

Also, check out his column at Smartkarma on the Asian market - www.smartkarma.com/profiles/steven-chen

Visit Steven Chen's Website


Rating: 5.0/5 (7 votes)

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Comments

Praveen Chawla
Praveen Chawla premium member - 7 months ago

I agree with point #2 but I may be misunderstanding the rest. Why not buy quality stocks, like some of the ones you have recommended, instead of the index when they are on "sale".

Steven CHEN
Steven CHEN - 7 months ago    Report SPAM

Thanks for the comment! The 1-4 recommendations at the beginning of the article aimed from the very "average" investors, who can't afford to spend a huge lot of time researching to pick stocks (at the right price). As for the more "enterprising" investor, buying quality businesses at reasonable valuations is the way to go, in our opinion, as the rest of the article implied.

tonymei123
Tonymei123 premium member - 7 months ago

True that challenge conditions will wipe out players with weak balance sheet and let stronger players take market share at lower cost than in boom time.

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