How to be prepared for inevitable stock market corrections

Sharemarkets can drift seemingly higher and higher without a hitch for many years, then one day due to sudden turbulence, markets will often ‘pop’ and correct. How can an investor be prepared for such unforeseen events?

Long term investors learn from experience that stockmarket sell offs happen on a fairly regular basis. These corrections, crashes or bear markets – as the media often likes to refer to them as - are an unfortunate, but inevitable part of every stockmarket cycle.

Corrections in the sharemarkets are a self-cleansing mechanism which occur to rid the markets of the speculative excesses generally built up as markets rise to new highs.

One can never accurately predict the timing of such corrections although many similar symptoms often exist before a correction occurs - such as high stock valuations, increased speculative activity in poor quality companies and general investor apathy. 

In addition, markets tend to sell-off and correct far more quickly and often fall further than many investors expect, as we saw recently when the ASX 300 dropped -13% in the 4 months from 29 August to 21 December 2018. 

The truth is that most corrections catch many investors off-guard, occurring when most investors least expect them. 

What steps can investors take to be prepared for such 'unexpected' and often painful events?

To ride out these difficult periods in the stockmarket, and to reduce the damage of what are often ‘unexpected’ falls, in our experience investors should bear in mind the following: 

1. Hold good quality stocks in your portfolio and understand where the company is aiming to be in the next 3 to 5 years

When corrections occur, you should always try to keep a level head. This is often not easy as the news headlines are full of dire headings and all sorts of ‘experts’ and market strategists seem to come out of the woodwork with all sorts of predictions of doom when sharemarkets are falling.

As a long-term investor, if your portfolio consists of quality companies then you should remain comfortable with your holdings when a correction occurs and not panic -  as many do when the sharemarket corrects. In fact, as a long-term investor one may even look to use any severe market weakness to buy more shares in the quality companies already held in your portfolio. Should prices become cheap enough, one may even use market weakness to invest in new quality companies that are now trading at a reasonable price.

Being invested in good quality stocks means a long-term investor can ride out the storm and as the legendary Warren Buffet has been quoted as saying: “be fearful when others are greedy and to be greedy only when others are fearful.”

As mentioned earlier, sharemarket corrections are a self-cleansing period in which speculative excesses of lengthy rising markets are cleaned out – thus in the 1987 stockmarket crash, it was the previously high-flying entrepreneurial companies such as Bond Corp and Bell Group that were the worst hit when the market crashed. In the sharemarket correction of 2001 when the US Nasdaq collapsed, here in Australia we saw previously high-flying companies caught up in the internet boom of the time such as Onetel, Davnet and Ecorp which were worst hit.  Similarly, in the GFC-era stockmarket crash of 2008-2009 it was highly geared companies like Babcock and Brown, ABC Learning and Centro that were worst hit. Most of the companies mentioned above never recovered either collapsing or trading at fractions of their boom time share prices. 

Another of Warren Buffet’s quotes which is very relevant at times of a sharemarket  correction: “you only find out who is swimming naked when the tide goes out.” In other words, it is often during and following market corrections when good quality companies stand out, when compared with many of the speculative ones which only looked successful because of a long running rising sharemarket when investors were willing to buy and back risky, low quality companies with very little substance. 

2. Investors should always hold a diversified portfolio of quality assets. 

Long term investors understand that all assets – whether shares, property or cash - go through periods where they are in favour and out of favour. In order to lessen the volatility of returns, it is always advised that an investor holds a diversified portfolio of assets across these different asset classes.  The percentage held in each asset class depends on each individual investor’s risk tolerance and investment objectives.

Within the equity portion of one’s portfolio, at IML we have always had a preference towards holding a diverse array of good quality industrial companies. This diversity ensures that the portfolio is not overly reliant on one or two stocks, or on one sector of the sharemarket (e.g. banks).  A diversified portfolio can help mitigate the impact of a downturn in a certain pocket of the economy as different companies have different drivers and underlying exposures to the economy. As an example, whilst a bank may suffer from a downturn in credit creation or an increase in bad debts, such an event in the economy will have a more modest impact on Consumer Staple stocks such as supermarkets or Healthcare companies such as CSL. 

In addition, in our opinion it is always advisable that the assets held – be they shares or property - generate a reasonable, sustainable income for the investor so that the portfolio can continue to generate an income return for the investor when asset prices are subdued.

In Lesson 4, we discussed the advantages of holding shares that pay sustainable dividends while in Lesson 14 we discussed the benefits of compounding – both of which are important lessons to always bear in mind in any correction in the share market.

3. Investors should never have their portfolio overly geared 

Whilst gearing one’s investments is fairly popular with many investors as it can work in an investor’s favour when share or property markets are trending higher, high gearing can also serve to magnify losses when markets go in reverse. In addition, too much gearing means the investor may be forced to sell assets when markets fall, interest rates rise or when banks tighten their credit criteria - the worst possible time. 
It is thus advisable in our view that investors keep any gearing to a minimum to avoid ever becoming a forced seller of assets.  

Some other pointers on how to cope with sharemarket corrections

From our experience over the last 20-30 years we have observed that in the initial stages of a correction in sharemarkets, it is not uncommon for almost every stock to fall as many investors rush to reduce their exposure to sharemarkets. It is thus very common to see indiscriminate selling across the market when corrections occur as what we refer to as the good, the bad and the ugly are all sold-off in the initial stages of a correction.  

In the last 10-15 years this indiscriminate selling has become even more common place thanks to the advent of algorithmic and computer-generated selling which often pays little regard to the quality of the shares being sold or the sustainable dividend yield payable by the shares being sold.  

However, when the panic subsides and sanity prevails - which inevitably happens - good quality companies with strong underlying businesses, and with real earnings always recover well. 

In fact, as mentioned previously corrections in the sharemarkets are self-cleansing mechanisms therefore and it is usually the speculative investments that are the main victims of sharemarket corrections. 

Thus over the last 30 years of ups and downs in the Australian sharemarket, the likes of  Bond Corp, Onetel and Centro have disappeared without a trace; while good quality companies with well established businesses, recurring earnings, that have carved a dominant market positions in their respective industries such as Woolworths, Events, Sonic Heathcare, Amcor and Brambles have continued to deliver solid returns and healthy dividends to shareholders. 

Whenever sell-offs in the market occur it is always worth remembering the words of renowned value investor Seth Klarman: 

“While it is always tempting to try to time the market and wait for a bottom to be reached (as if it would be obvious when it arrived), such as strategy has proven over the years to be deeply flawed. Historically little volume transacts at the bottom or on the way back up and competition from other buyers will be much greater when the markets settle down and the economy begins to recover. Moreover, the price recovery from the bottom can be very swift. An investor should put money to work amidst the throes of a bear market, appreciating that things will likely get worse before they get better.”

Conclusion

Corrections are a natural part of all sharemarket cycles. The best protection for long-term investors in all price downturns is to be invested in a diverse range of high quality, income producing assets; to stay calm and to see if opportunities emerge where one can add good quality assets at depressed prices to one’s portfolio. 

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You can read more of Anton’s 20 lessons from 20 years of years of quality and value investing here