A template for successful investing during bear markets
Coronavirus, something which most of us had never heard of a few months ago, has quickly established itself as a defining event of our time. Economies around the world have been upended as people cease to work, and lose many of the day to day freedoms we take for granted. The equity market reaction has been particularly vicious, with a bear market establishing itself just weeks after the ASX was trading at record highs. These are truly unprecedented times, but each market cycle is unique – and this matters a lot when it comes to managing portfolios. In this article we will highlight some of the key skills we believe investment managers need to master, in order to successfully navigate bull and bear markets.
Discipline & Patience
The small cap stock universe is an incredibly broad universe made up of some companies which are world class innovators, and others which are unprofitable basket cases. For managers of small cap equity portfolios, the secret to generating strong long-term returns is finding those few truly outstanding companies. Given there just aren’t that many ‘diamonds’ out there, it’s essential that when you find a company with highly talented management with an outstanding process and product or service, that is trading at a fair valuation (or better), you really ought to stay invested for a long time. This process of finding great companies early on in their life cycle, and then owning them for a long time, means the portfolio manager is not having to ‘churn’ their portfolio in attempts to ‘out trade’ others in the markets.
Maintaining such a disciplined approach requires a good deal of patience, but over time this patience creates wealth. In fact, patience and the persistence to stick to their plans, is probably one of the best qualities for a small cap portfolio manager to have. They usually do not feel bad about the 10% fall, as they would rather sit tight to celebrate the 100% gain.
Experience reading markets
Anyone can study investment analysis, but to invest in companies successfully over the long term often requires a curiosity and synthesis of knowledge from a number of domains that can’t easily be taught. Those who are successfully able to do this often talk of seeing the market as a mosaic and are able to make sense out of disparate and often conflicting pieces of information spanning financial, economic, political and social elements. The skills portfolio managers require to take decisive action under such conditions are built and honed through the most extreme market swings and gyrations which play out through a full economic cycle. In this way successful investing over the long term is similar to other professions. The accountant, dentist, doctor, lawyer or plumber becomes a more skilled practitioner the wider the range of cases they have experience in dealing with. One key difference with investing is you know that your case (your investment), if you are a long-term investor, is sure to be tested through a wide range of cases (wild market conditions) at some point, and not just the normal conditions that prevail most of the time. In this way, experience through both good and bad markets is a very important requirement of your portfolio manager for your investments.
Understanding risk and volatility
Bull and bear markets force one to truly appreciate the inherent risks in investing. Through these periods, investment managers develop a more highly tuned framework, which guides them to balance any risks being taken with the expected returns on offer. This will involve setting risk limits such as maximum weights on a stock, sector and investment style basis, which may change at different part of an investment cycle. It also requires a process for deciding which losers to cut and when to sell to prevent big winners from turning into losers. And given it’s no good being long-term right if the losses from short-term moves prevent you from holding onto some of your best companies, controlling the volatility of the portfolio will be particularly challenging at market extremes.
Confidence, independent thinking, and the ability of knowing when to be a contrarian, are also skills portfolio managers will need to utilise through gut-wrenching bear markets and euphoric bull markets. Bear markets will often present value investors with once in a decade bargains, as distressed markets fail to distinguish between high-quality and low-quality companies. Similarly, a portfolio manager needs to know when to ‘lean against the crowd’, and to take profit on some of the market’s best performing growth stocks. As experienced portfolio managers have spent many years analysing the fundamentals of the companies they invest in, it follows that they already have the key knowledge to anticipate risks, and have set out defined plans for both entry and exit points.
Learn from mistakes
Confidence is important but must also be balanced with humility and reflection. Portfolio managers who have been through multiple bull and bear markets are not afraid to own their mistakes, and to thoughtfully learn from them so they are not repeated. Mistakes should be taken hard, but in a business where share prices are giving you daily feedback, you also need to move on and focus on the cycle unfolding ahead. No portfolio manager gets every stock right in competitive markets, but the more successful must be willing to quickly learn the lesson from mistakes, make any adjustments to the investment process if necessary, and get back to work on the next investment idea.
History can often guide investors, but each market cycle is unique – and this matters for managing small cap portfolios. At Ophir, our investment approach helps our portfolio managers and analysts identify the stocks that should outperform as the economy moves through each stage of the cycle; expansion, slowdown, recession and recovery. Depending on the phase, the share price performance of different types of companies will react in different ways. By identifying the current stage of the business cycle, we aim to anticipate and capture the best investment opportunities.
Each market cycle is unique
As investment markets can be emotional, attractive opportunities can also arise to own unloved yet fundamentally sound businesses.
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Luke has over 17 years of experience in the financial services industry working in several investment research, management and advice roles. Prior to that, Luke was a professional basketball player in the Australian National Basketball League.