Market Insights

Autumn 2017 Investment Update -- Why We Invest

After market downturns it is often important not to let fear of further declines cause investors to sell down their positions at what might be at or near market lows.  The harmful effect of such panic selling is often exacerbated by then having to pay capital gains taxes on long held positions.  Yet another harmful effect of selling after a scary dive in financial markets is that the money generated is then held in cash, probably earning little in the way of returns for the indefinite period before an investor regains confidence in investing and finds suitable investments.

At market highs as we have today, the question becomes should investors do the opposite of the above advice?  That is, in a market making new highs, should investors sell off pricey stocks, raise cash, and wait for a better entry point?  Our answer at Arrival Capital is mostly "no" but a little bit "yes."  Let us take a deeper dive.

Investing is a serious endeavor meant to increase wealth and thus purchasing power for an individual, family or institution over the long term.  It is not a sport or a game, or a means of keeping score.  Therefore, as investors, we want to at a minimum have our wealth and purchasing power at least keep up with economy as a whole, including inflation and, if at all possible, have investment returns that exceed the growth of the economy, as measured by inflation-adjusted Gross Domestic Product (GDP), or, if we get really ambitious, a large cap stock index, such as the S&P 500 index.  The reason we want to exceed these returns is because over the longer term we and our families will be competing with others to purchase the types of goods and services that are necessary for maintaining and improving upon our quality of life.  What now might seem affordable for a family, for example a year of college, could in fifteen, twenty or thirty years no longer be affordable if our purchasing power does not keep pace with the costs that figure, in this case, into tuition.  The same holds true for other big ticket items like a house, or long term elder care.  As a an example, back in 1985, the annual tuition for an Ivy League college was approximately $9,000.  Last year, that tuition was over $45,000.  Tuition increased at a rate of about 5.3% a year.  To the extent your total wealth increased by less than this amount (including the portion of your salary you saved), you were falling behind each year in your ability to afford tuition for your family's next generation.  On the other hand, the return of the S&P 500 index averaged 8.3% a year.  Thus, even with a five-fold increase in tuition over thirty-plus years, if you or another family member (fostering inter-generational family wealth generation is another important topic) had taken that $9,000 back in 1985 and put it in the S&P 500 index, not only could you pay for college today, but you actually would have money left over for other spending priorities, and this after a period of time that included the 1987 market crash, the 2000 tech stock implosion and the Great Recession of 2008-09, when stocks lost more than 40% of their value.

This spending power analysis is a long way of answering our initial question -- no, one should not engage in market timing and sell off stocks just because we are at market highs.  The goal is to outpace inflation and GDP growth.  A soaring stock market is at least in part reflecting a strong economy and healthy GDP growth.  Investors need to equal or exceed this growth to keep pace.  There is no edge to this type of market timing, the result will probably just be losing ground to the economy as a whole.

What about those who wish to exceed market averages?  Can't we cut back exposure to stocks at record highs and then add back a little bit lower?  Again, we would urge caution to such an approach.  Rather, we would focus on the individual stocks and investments owned by an investor not the market as a whole.  This is where our value investing approach comes in and we come up with the little bit "yes" response to the question of what to do at market highs.  Value investing is meant to increase the odds that our downside is more limited than the market as a whole while our upside is at least as promising.  This has two benefits:  (1) even if the market falls, say after an unexpected event or a rapid economic decline, a value-based portfolio should decline less than the market (and GDP), furthering our goal of staying ahead of the economy, even as it falls on an absolute basis; and (2) value investing analysis will constantly look to add investments that remain relatively cheap to a portfolio while removing those whose value is now deemed to be far less than the current, inflated market price (taking into account taxes that come due when a long held investment winner is sold).  This value investing mindset, combined with an individual risk assessment focused on risk tolerance and current income needs, thus leads to a built-in and ever present response to a record breaking stock market and hopefully avoids the attendant acrophobia that many investors apparently are feeling right about now.

An old investing adage is cut your losers and let your winners run.  On first blush, that sounds like a recipe for momentum investing.  But it is really a recognition that certain businesses can achieve such a level of market dominance, positioning and scale that they will continue to grow revenue and profits, and thus become ever more valuable as investments.  Such may be the case for some of today's tech giants, with only the threat of government intervention as a future potential value killer.  That means stock price increases alone should not cause an investor to get ready to sell.  Don't throw away a business with good value just because it's stock price has gone up!  At the same time, there have been ample opportunities over the past few years to pick up good value that remains after investors have thrown away stocks in a myriad of industries, including financials, industrials and media.  Today, if one treads carefully, there continue to be opportunities in beaten down sectors like retail, restaurants and energy, as well as the constant generation of opportunities from spin-offs, special situations and, occasionally, a new business or product that is slow to have its value recognized.

Combining the great companies that will get better, with the good ones becoming great, and the sick but cheap businesses becoming healthier, there is a recipe for portfolio construction that can stand the test of market highs and lows and, over time, lead to the type of wealth maintenance and generation that will truly lead to a better life for ourselves and our families.  Let Arrival Capital help you do this today.  Enjoy the Autumn!


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