How does one approach equity at an all-time high?
As humans, our brains are wired to react badly to negative news rather than react well to positive news. This has a natural implication for us as investors, in the equity markets. We, as investors tend to panic when the markets fall and this worries us more than the joy we get when our portfolios are doing well and our returns compound.
However, there is a very interesting trend in the equity markets that make us worry as our returns increase – and this is the noise we hear around the markets correcting a lot as the valuations reach an all-time high. Combining the two, equity markets is the only place where we worry or panic during a bear market, which makes us jittery to stay invested. And so do we worry as markets hit all-time highs as we are concerned about an impending correction around the corner. It’s this dichotomy that we as investors are faced with every year in the markets.
When faced with a dichotomy, it always helps to zoom out a bit and look at data for comfort around what we can learn from history.
The table below gives an overview of S&P returns (a proxy for US markets) over the last 80 years. The highlighted buckets list the number of highs the market makes each year. There are two important takeaways that I would like an investor to take away from the table.
a) New highs in the market happen around clusters in the last decades.
b) There have been an impressive 50 new highs in S&P 500 in 2021. The highest one has ever seen was back in 1995 where we saw 77 new highs.
The last decade (2010-2020) saw the same index fall by 20 per cent or more five times. It's important to realize that this is the very nature of markets, and not something which will change either in the future.
Graph 1: Historical representation over 100 years for the US Indices for new highs
Source: Factset Data
The reason US market data has been shown is one can go back longer in history to analyze the data.
It is important to realize that new highs in the market do not mean much in terms of being cautious or exiting the markets or taking money off the table. A new high means two things
a) The expectation of growth is robust.
b) This will create a cycle of capital deployment and the two will reinforce each other positively.
During such times, the optimism is generally high, which is expected, and the discipline of an investor will often get tested. It's during such times, that going back to the basics of investing, where focus on cash flow growth (which is the true health of the business) will hold the investor in good stead to continue growing returns in their portfolios.
Today, when one looks at portfolios across holdings, be it self-managed, or professionally managed, the return numbers would be healthy. During such cycles, the allocation of new money generally becomes lax around risk-taking (this is akin to most accidents while driving on highways, and not on crowded roads).
There are three broad takeaways I would like an investor to take away during such markets:
a) Have a higher tolerance for a business into the portfolio investment that you make - It's very easy in a market like now, to look at past returns and make business allocations and portfolio decisions. However, this can easily result in loss of capital if one deviates away from fundamentals. Today, more than 40 per cent of the listed companies have shown greater than 100 per cent returns in the last year, with no improvement in cash flow growth. These businesses are the highest at risk as the market continues to move higher.
b) Do not focus on new ideas every month - The equity market is not meant to give you an adrenaline rush but is meant to give you consistent returns. However, very few businesses can generate this consistency. Its important investors continue to keep the focus on businesses that are growing, gaining market share and have higher than expected corporate governance today.
c) Valuations matter, but growth has more of a fundamental basis to it - It's always important to realize that the valuation one buys a business will have a bearing on the return one makes in the portfolio. However, over time, what matters is the cash flow the business throws in its balance sheet and if this continues to grow. If the latter does not happen, the valuations have less significance. It is imperative now, more than ever, to focus on the businesses whose cash flow is growing giving the management the optionality to reinvest the capital into the business. This is where true compounding happens.
The markets at every all-time high will be expensive. This is not a new phenomenon – neither is the subsequent volatility that investors will experience in their portfolios. The most important thing that investors need to take away is to continue to focus on the individual businesses around cash flow growth and to control greed during such markets. We are coming off the worst decade of equity returns in India (2010-20) and we should see this reverse in the next decade.
Naveen Chandramohan, Founder and Fund Manager at ITUS Capital, a PMS firm running a multi-cap fund (www.ituscapital.com)