Rates, AI and Oil – there’s plenty to worry about

Market downturns have a way of making the most confident investors question their convictions. Prices fall, headlines scream and suddenly the most persuasive voices are the ones explaining why things could get worse. Bearish narratives sound more intelligent than bullish ones. Bears sound prudent and come armed with a laundry list of actual or potential reasons to worry. While bulls struggle to disprove something that has yet to happen. But while bears often sound smart, it is typically the bulls who, over the long-term make money.

Successful investors recognise that volatility and setbacks are features inherent of equity markets. To steal a line from the tech world; volatility is a feature not a bug. The challenge is not avoiding downturns altogether – that’s impossible – but responding to them in a way that lets you stay in the game.

Taking a long-term view

Equities are long-duration assets. Their value is determined not by what happens over the next quarter or year, but by what businesses earn over their lifetime. Yet during market sell-offs, investors often become intensely focused on the immediate future.

Short-term uncertainty becomes magnified. Economic forecasts are revised down, analysts debate the likelihood of recession, and market participants attempt to position portfolios for the next few months. In doing so, they often lose sight of the far more important question: what will these businesses look like five or ten years from now and what am I paying to take on this uncertainty?

Temporary volatility rarely changes the long-term economics of a high-quality company. A cyclical slowdown might affect earnings for a period, but it usually does little to alter structural advantages such as cost leadership, network effects, switching costs or intellectual property.

Leaning on history

Every downturn feels unique in the moment. There is always a catalyst; inflation, geopolitical tension, monetary tightening, technological disruption, a pandemic or some combination of all of the above. Right now, it’s AI and an oil shock. The details change, but the pattern is the same. Markets fall, sentiment deteriorates, and pessimism spreads. Yet over time, economies adjust, businesses adapt, and markets recover.

History is helpful here. Equity markets have experienced wars, oil shocks, financial crises, pandemics, and countless recessions. Each episode was accompanied by compelling arguments explaining why “this time is different” and how it could get worse. Those arguments rarely aged well.

For long-term investors, the lesson is not that downturns should be ignored. Rather, it is that market declines are a normal and recurring feature of investing. Attempting to avoid them by exiting the market often results in missing the recovery that follows.

We are not fans of complacency. Rather paranoia should be focused at the company level. Emphasis should be placed on each companies competitive positioning and the capability and integrity of management. This is where we focus our time; in good markets and bad.

Don’t underestimate the ability of companies to adapt

One of the most common mistakes investors make during downturns is assuming that businesses are static. When conditions deteriorate, projections are often built on the assumption that companies will simply endure the environment exactly as it exists today.

Good companies adapt. When meeting the management and boards of companies we own or are researching, we spend some time handicapping the probability of these companies’ ability to adapt to an uncertain future. Unsurprisingly we find companies where management own a lot of stock, have and emotional attachment to the business and have a track record of adaptation (say in Covid for example) are best placed to deal with future shocks.

In the last five years, I have noticed a trend to management teams being even more adaptable than in the past. Management are faster to cut costs, adjust pricing, refine strategy, invest in new capabilities, and reposition their operations. Some of this was driven by Covid where external forces were so severe, adaptable and aggressive boards and management had licence to make changes that would have been seen as too bold in ‘peacetime’ conditions.

Adaptation is not limited to day-to-day operational changes. The best companies use macro uncertainty and a strong balance sheet and support of capital markets to acquire competitors or opportunistically buy-back their own stock at opportune times. The value of this cannot be underestimated.

There’s always something to worry about

At any given moment, markets are surrounded by risks. Interest rates may be rising. Inflation may be proving stubborn. Political uncertainty may be increasing. Global growth may be slowing. The list is endless, and it is rarely difficult to construct a persuasive argument for caution.

The problem is that markets rarely provide a moment when all concerns disappear. If investors wait for complete clarity before committing capital, they may find themselves waiting indefinitely.

Periods that feel uncomfortable often coincide with the most attractive investment opportunities. When uncertainty is high, risk premiums rise and valuations fall. That is precisely when disciplined investors can acquire quality assets at more attractive prices.

The paradox of investing is that the best opportunities often emerge when confidence is lowest. We believe we are in one of these times right now.

Price and fundamentals are not the same

Finally, it is important to remember that price and fundamentals are not the same thing.

Market prices move constantly. Some price moves are rational. Rising interest rates, all else equal, reduces the value of financial assets. We are not loving the Aussie 10-year at almost 5%. However, some price moves reflect shifts in sentiment, positioning and liquidity. These forces can cause substantial volatility even when the underlying business is performing broadly as expected.

A falling share price can feel like confirmation that something is wrong. But unless the underlying fundamentals of the business have deteriorated, a lower price simply means the asset has become cheaper. It’s our job to determine the one from the other. The objective is not to own stocks that never fall. It is to own businesses whose intrinsic value grows over time.

Staying the course

Market downturns test conviction. They amplify uncertainty and reward the most persuasive pessimists. Fear is a powerful emotion. But the historical record is clear: those who remain invested in businesses that grow their earnings through time are the ones who benefit from the market’s long-term upward trajectory.

It sounds prudent to be cautious, especially right now. But for patient investors focused on quality companies, this is not the path to long-term success. Remember, bears sound smart, but bulls make money.

Chris Prunty is a Portfolio Manager at QVG Capital. QVG is hosting a webinar to that is open to all on Wednesday 25 March. To register for the webinar click here