SI Research: How To Invest In Late Cycles?

There is an adage that says: “Bull markets do not die of old age but ended by recessions”. As we sit today on 25 October 2018, following the US market’s plunge overnight, the local benchmark Straits Times Index (STI) broke below 3,000 points. Since peaking in April this year, the STI has been trending downwards on weakness. At the current level, STI just needs to shed another three percent to officially enter bear territory.

Yet, both the global and local economies are still in the pink of health. Even though experts have been “softening” their estimates, latest data still showed robust growth for the rest of 2018. For the global economy, the International Monetary Fund recently snipped global expansion down from 3.9 percent, but still expects the global economy to achieve a 3.7 percent growth rate for this year and next. Over in Singapore, the local economy clocked 3.8 percent for the past nine months, its best performance since 2013.

Whilst higher interest rates and escalating trade tensions have indeed dampened the economic outlook, inflation risks have yet to rear their ugly heads. In the US, the Federal Reserve’s (Fed) preferred inflation gauge, the personal consumption expenditure (PCE) price index only increased 1.8 percent in the latest quarter, slowing from 2.1 percent in 2Q18. Meanwhile, Singapore’s core inflation also eased slightly to 1.8 percent in September from 1.9 percent a month ago.

Forget The “Bull Or Bear” Label

Long story short, forget about the “Bull or Bear” label. More importantly, investors should recognise that global growth has only begun accelerating in 2017, after years of tepid growth following 2008’s financial crisis.

Notwithstanding that, the Fed is charged with the dual mandate of “curbing inflation and maximising employment”. What this means is that the US central bank would – in all its abilities – try to steer the US economy from a recession.

Never mind all the noises Trump makes. It would be wiser to place your faith on the collective wisdom of the US Fed board members not overshooting interest rates. If US and China could reconcile their trade imbalances, what should (hopefully) ensue is a clearer environment that would bring healthy economic expansion along with normalised interest rates. These two elements combined still set for a good period for investors to stay invested.

Buffett’s Wisdom

The Oracle of Omaha has lived through numerous cycles of high inflation and interest rates. So, if anything, his wisdom and experiences are invaluable.

The current US inflation rate would be considered miniscule compared to the 1970s and 1980s. During 1965 to 1982, inflation in the US spiked as high as 20 percent. Some viewed the great inflation as one of US’ defining macroeconomic failure post-World War II period. It was also a lost decade for stocks.

While the conditions of a big decline have yet to take form, investors need to keep watch for signs of inflation. Especially during late cycles, inflation could perhaps be the most important economic variable. As Buffett once explained, inflation consumes capital, which is bad for businesses.

Focus On Quality

While stock valuations were slashed amid the broad-based decline, do not just merely buy stocks because they are cheaper. Instead, the importance of focusing on quality is amplified during late cycle investing. While fast growing companies often excites investors and draw the attention, “weaknesses” in the balance sheet could become the pitfall for these companies when recession hits.

Ideally, investors should look for a great business that generates positive cash flow, so much so that it could fund operations internally. That means, taking on debt is a choice instead of a necessity and no-strings attached cash is always good. Great companies should also boast a robust balance sheet that can withstand negative shocks in a prolonged period.

With a deep respect for fundamentals, investors can then pick up stocks at reasonable multiples. That brings us to the next point.

Protect Your Downside

The most important rule to Investing101 is to protect your downside. In Buffett’s words, it means “Never lose money.”

The desire to making quick money is extremely dangerous. Yes, we pride ourselves for being able to spot stocks that delivered substantial returns for our readers. But we are also cognizant that the luck factor played some part.

At Shares Investment, we tirelessly scour hundreds of stocks and news every day to look for great companies which we believe have great potential. When they deliver, we would be elated. But we are also proponents of protecting investment capital.

In times of uncertainties, volatility can be great and placing your money in a single bet can be an extremely silly thing to do. The odds of losing are even greater during late cycles. As any seasoned investor should know, a 50 percent loss needs a 100 percent gain to recover. Increase that loss to 80 percent and you would need a 500 percent gain to recover. This risk can be reduced by simply diversifying your holdings.

Avoid Confirmation Bias

This leads us to our final point. In a falling market, do not fall victim to confirmation bias. Unlike most of the other aspects to investing, confirmation bias is a self-made circumstance that is very much within an investor’s control.

When your portfolio of stocks is going into tailspin, do not let your emotions run high and cloud your judgement. Rethink your thought process and do not seek information or signals that just vindicate your original thesis.

A confirmation bias will make an investor ignore details or facts that refute his own decision and only make him focus on optimistic information. So, if your all stocks are plunging, rethink your strategy: Is your portfolio too heavily-concentrated on a single sector? Are your stocks plunging because of market sentiments or changing fundamentals?

If your gut feeling is telling you that you have made a mistake, chances are that you probably have. Do not hesitate to cut your losses and rotate into other stocks. Recognising your mistakes is the first step to making right choices.

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