Such periods are never easy for the investor to navigate through, although, as I wrote in an earlier blog (link), stock market corrections are normal and recurring.
However, I believe that the long-term investor who espouses a “value” investment philosophy has a significant advantage over other investors, especially speculators.
In times such as these, it is reassuring to know that one has invested in solid companies, whose business models have proven their worth, which are profitable and in solid financial health. One can always try to assess the downside risk of a security that one holds by asking two questions:
1. How much could the company’s profits fall? It is likely that an economic slowdown will occur in the coming months, or even a recession. What could be the impact on company profits?
2. Based on this estimate, what might be the valuation ratio that investors would be willing to pay for this company’s stock, assuming a pessimistic scenario?
When I examine each of the securities in our portfolios under management, I can get a good idea of the answers to these two questions. A very pessimistic scenario could result in a continuation of the decline in the value of our securities over the next few months, but it seems to me that there is nevertheless a floor to this value.
What about companies that are currently not making profit and are expected to continue to lose money for the foreseeable future? It seems to me that in such cases it would be difficult, if not impossible, to estimate a bottom value. The problem with many of these loss-making companies is that they will likely need capital to continue their operations just as the market for capital becomes increasingly tight.
I would not like to find myself in that situation.
The same is true for companies that are deep in debt. These companies find themselves in a situation where access to equity capital is suddenly very limited and new debt suddenly costs much more than in the past. For example, according to the Federal Bank of St. Louis (St. Louis Fed), the spread between rates on junk bonds and US government rates had climbed to 4.71% on May 16, 2022, compared to just 3.27% on April 5 and 3.03% on December 29, 2021.
Same thing for those who own cryptocurrencies. What benchmark can they use to get an idea of the downside risk of bitcoin or other cryptocurrencies? The big problem with such “currencies” is that there is no way to evaluate them objectively.
During such a storm, I like to review each of the securities we hold in our portfolio. And I take comfort in confirming that each of our businesses 1- is profitable; 2- has a robust and sustainable business model; 3- is in good financial health (at least, for the vast majority of them) and 4- its stock is reasonably valued.
In such conditions, all you have to do is be patient and let the storm blow over.
