Every downturn is different – the Global Financial Crisis and the Asian Financial Crisis were primarily debt-related, while SARS and Covid are obviously health-related, with a knock-on effect on growth and consumption.
Having lived through these tumultuous periods and witnessed numerous crises, the three key lessons I have learnt over multiple market cycles are as follows:
1. Invest in high-quality companies
The very best (and we think somewhat proven) way to deal with an unpredictable future is to simply focus on buying high-quality companies. It is really a very simple idea: whatever happens, the best companies will either prosper in easier times or, contrarily, suffer the least in adversity.
We believe that the most obvious markers of a quality company are a high return-on-equity (ROE), alongside a reasonable growth rate in a relatively predictable and sustainable fashion. We consider these factors over a medium-to-longer term time-frame, by which we mean at least 3-5 years.
More specifically, we think people (and the management team in particular) are the key magic ingredient that make great franchises and drive returns. In addition, some businesses are just that much more predictable (think consumer staples, rather than capital goods) from our view.
The sustainability of a business (which includes “hard” ESG data) refers broadly to a company’s staying power. It includes their licence to operate and thrive, as well as endure. Over the years, we have found that those companies that treat their staff well, pay their taxes and behave properly, unsurprisingly do better than those that don’t.
2. Pay a reasonable price for them
We have never sought to systematically buy companies cheaply, appreciating that quality usually comes at a price. You get what you pay for, as they say. By contrast, we have always sought to pay a sensible, or a reasonable, price for the companies that we want to buy.
That is easier said than done, at times, when valuations in bull markets reach extremes, and every day seems to bring new risks. In these circumstances, we remain optimistic but ever mindful of the signs of euphoria and the growing risks to capital preservation.
Assuming our analysis is correct and we manage to buy high-quality companies at sensible prices, to us the results and the outcome are clear. Over the long term, we believe we should be able to compound client returns at an absolute rate of 8-10%+ per annum (p.a.).
Looking back at our 30-year track record that the expectation has indeed been true, though of course there is no guarantee of that in the future. Most imperatively for investors, that level of return is materially better than inflation, the market and a number of alternatives.
3. Maintain discipline and conviction
As we all know, markets are highly effective discounting machines. When all are fearful and the headlines are unrelentingly negative, there is a reasonable chance that much of the downside has already been reflected. It seems easy only with the benefit of hindsight, but as markets move from extreme fear to full-on elation, it is important not to become mired in pessimism (or, conversely, get carried away during times of market euphoria).
Equally, it is important to recognise that we are often our own worst enemies when it comes to investing. As social creatures, people and especially investors often behave in a pro-cyclical manner. Stress, when cycles and prices go against you, often drives bad decisions.
Because of the nature of the high-quality companies that we own, top-down-driven downdrafts tend not to result in a permanent loss of capital. The impact is usually more transient. High-quality businesses usually recover more quickly and may even gain advantage in a more difficult environment. That tends to mean that our portfolios hold up relatively better in more difficult times.
When the market-tide goes out, as we saw most recently with Covid, it is much easier to resist your own panic-demons if you own high-quality, reasonably-valued and well-capitalised businesses. The hardest part is the essential discipline to do nothing, other than to consider the bargains being offered by the market. It is clearly much easier to do this from a position of strength and resilience when you own high-quality businesses in your portfolio.
While there is always plenty to worry about, in reality most of this angst is wasted. Our observation is that worrying clearly works because 90% of the things that we worry about never happen. In that vein, we are determined to remain positive about the likelihood of progress.
To us this much is clear: by investing in high-quality companies, paying a reasonable price for them, and maintaining the discipline and conviction of our investment approach, we believe most of the companies that we own are likely to be worth substantially more in three, five and ten years’ time.