Being a patient investor in a persistent market downturn

Every investor knows the saying that investments can go down as well as up in value. Knowing and seeing this in action are two different things however, and my perception over the last 24 months has been of a huge number of investors disappearing from social media. After a decade of low interest rates and loose fiscal policy, many retail investors have become addicted to asset inflation. With more money in the system and borrowing being cheap, investing in the majority of assets has simply been a case of ‘buy and hold’, with even non-existent ‘art’ in the form of Non-Fungible Tokens (NFTs) being the source of huge speculative cycles.  The reuslt of this has been a lot of investors talking about being a patient investor when they’ve really been speculators – investing in a company in the hope that someone else will pay more for it.

This environment has been hugely rewarding for speculators and hidden the importance of being a patient investor. Small caps, large caps, index trackers, property, fine art, classic cars, coins and stamps, watches – the price of every asset imaginable has exploded in value over the last decade. This has bred a generation of investors that have only ever seen assets increase in value, almost regardless of quality or strategy. Although crypto-currencies and NFTs are the most extreme examples of this, retail investors have also benefitted from an environment in which assets appreciated in value almost automatically. As such, it’s been easy to talk about the importance of being a patient investor but without any need to demonstrate it.

These same speculators have scattered, however, as market conditions have worsened. Quantitative tightening is reducing the money supply, interest rates have reduced demand for borrowing, and inflation is reducing household’s ability to save money. In addition, savers are now able to access guaranteed capital returns of over five percent for cash savings, reducing the attractiveness of equity investing. Remember the average returns over time for equities are only 6-8% a year and are not guaranteed. Many speculators are quite happy to accept 5-6% a year in cash for zero risk, further reducing the amount of capital being added to equity markets.

In the face of billions of pounds, dollars, yen and euros being pulled out of global equity markets, indexes are stagnating and the ‘riskiest’ assets have collapsed in price. Companies failing to generate a profit are not selling their goods and services for economic value – they never were – but now investors are not willing to pour cash into a potentially endless black hole in the hope of future profits. Companies with low turnover, likewise, are not market leaders but unproven speculative investments. As more and more investors lose interest in holding positions in these companies, their share prices decline – in some cases by as much as 70 or 80 percent.

A bull market floats all portfolios

A good example from my own portfolio is my position in S4 Capital, which I bought in early 2022 at around £5. At the peak, this company was valued at £8 a share but recently fell under a £1. Since being listed in 2017, the business has grown it’s revenue more than 20x but has never turned a profit. Its share count has more than doubled over the same period, hugely diluting shareholders and its founder, Sir Martin Sorrell has repeatedly given testy interviews in which he insists losses are nothing more than an accounting technicality.

Unfortunately for him, the market remains unconvinced and clearly lost patience with his ‘growth at any cost’ approach, resulting in an enormous devaluation of the shares which have left them languishing at less than half of their listing price five years ago.

In a world of 1% interest rates and constantly quantitative easing, this was exactly the sort of business that investors could believe was the company of the future – leading to an enormous speculative bubble that was later smashed on the rocks of economic reality. As an investor in S4 Capital, my own paper losses in the company are some of the worst I have ever faced – I still hold the company in the hope of future profitability but am largely resigned to the fact that I bought too early and should have stuck to my rule ‘no unprofitable businesses in the portfolio’.

As a patient investor, I understand the importance of both limiting risk in my portfolio and also structuring it in a way that enables me to hold positions for the long-term. As a result, my portfolio is well-diversified, meaning that although this investment has not worked out, the paper loss currently represents about 1.5% of my portfolio value. Although unpleasant, it is an outlier and as such I am able to bear it and give time for a potential improvement in performance.

By comparison, I have seen many anonymous accounts on social media that have gone dormant after repeatedly covering positions in small, speculative and loss-making businesses that seemed to make up the majority of their portfolios. In a world where S4 Capital was valued at £8 a share, investors looked like geniuses, but as the company de-rated, a portfolio full of S4 and similar businesses would have lost a tremendous, perhaps irreversible value of capital.

S4 Capital is perhaps an easier mistake to avoid than many ‘high quality’ small cap shares that were previously social media darlings. One popular pick among small cap investors is the business Somero Enterprises, a UK-listed concrete machinery business. I don’t have a position in the company, but know of many retail investors that do. The business turns over around £100m in revenue, has a consistently strong 30% operating margin, no share dilution, and is net cash. On paper, this is the perfect candidate for an investor seeking growth potential and quality. At its peak, the shares appreciated from around £1 a share in 2015 to £5.50 in early 2022, before falling to £2.80 in early September 2023 (and looking to be in freefall). This business ticks many of the boxes that quality investors love – it’s profitable, it’s growing, it has strong margins, it pays a well-covered dividend, it has net cash, and there is no shareholder dilution.

The problem becomes its attractiveness in a world where investors can get 6.5% on cash. The shares currently yield around 8% but in the last twelve months have lost nearly 50% of their value. In a world where prices are increasing at 10% annually, investors can guarantee a loss of 4% of purchasing power a year in cash, or risk 44% losses on Somero. I don’t think it takes a genius to see why many are opting for cash over exposure to the equity risk.

A bear market leaves nowhere to hide

In this world, a great many investment commentators and ‘gurus’ are disappearing. X, formerly Twitter, is a graveyard of dormant accounts from historic, self-declared experts that have simply disappeared in the face of overwhelming losses. In a portfolio where 90% of their positions have Somero-like returns and after two years of losses, these accounts have scattered to the four winds.

Unlike these accounts, I am still present, active, and engaging with fellow investors, but I come bearing a repeated warning. Investors need to be very, very careful who they follow online and how they respond to information. If investing was as simple as running a screen for fundamental performance and buying the best performers, everyone with access to the internet would be a millionaire. If investing was as simple as buying a good story, every investor that attended a shareholder networking event would be a billionaire.

Investing is not simple and losses can be incurred in a variety of ways and for a variety of reasons. Having been an investor for more than ten years, I have met a huge range of investors but the best are those that recognise the impact of randomness and luck in their portfolios, and are actively trying to refine their approach over chasing tips.

I understand the allure of anonymous accounts and share tipping services that have pulled retail investors onto the rocks. The thought of ‘following along’ with an expert and generating outsized returns is attractive – especially if it reduces the time and inherent uncertainty of managing your own book.

A patient investor stays the course

My message to readers facing a tough time is to remind you that we all are. Market conditions have shifted and many risks previously hidden by low interest rates and loose fiscal policy are coming to the fore. Some of the world’s ‘best’ fund managers have generated disappointing returns over the last 24 months – and could well for another 24.

This is the reality of the phrase ‘past performance is no guarantee of future success’ – market returns are not a guaranteed outcome in the short-term, the mid-term, or really any term. Share price performance over the long-term is a reflection of company’s expected cashflow and underlying earnings. Targeting positive and growing earnings per share, the value of net profit divided by the total number of shares outstanding is a consistently reliable method of generating returns but those returns are not exactly linear and the earnings themselves will be valued differently at different points in the market cycle.

Markets are, by turns, overenthusiastically bullish and depressingly bearish. During the bull markets, any investor picking a random selection of profitable shares will likely generate a positive portfolio return. Likewise, during a bear market, even profitable companies can be discounted far below their intrinsic value. This masks the strength of the patient investor and inflates the skill of the speculator by comparison.

My job as an investor is to identify the intrinsic value of the earnings generated by a company, model these into the future, and then purchase a share of those earnings at a reasonable price. The factors that play into this intrinsic value are many and include reliability and scale of earnings, return on capital employed, use of debt, market sentiment and industry performance.

At any point in the investment cycle, I compete against thousands of other investors to determine the intrinsic value of a company and to gain a share of the earnings of the most desirable opportunities. Some investors will be willing to pay twice my valuation, others will be willing to pay half, yet more will not be willing to pay at all. Likewise, when I make an investment, it is my role to determine what the likely future outcome of the business will be – are earnings growing and are they becoming harder or easier to generate? How does this business compare to others in the market? Is it still an attractive opportunity relative to others?

A share price is an attractive distraction from asking these questions – when the price goes up, an investor naturally feels they are justified in their decision, and when the price goes down, an investor feels they have made the wrong decision. This, in and of itself, is not actually accurate. If a large percentage of investors purchased Somero for income in 2020, judging that it’s 5% yield was more attractive than a savings rate of 2%, then the same investors would likely not have bothered making the investment if they could receive 6.5% from a cash account at the same time. In the former case, the price may well appreciate but in the latter, it may decline.

Neither of these decisions, however, are based on a decision about the underlying performance of the company, and so movement in the share price would be entirely disconnected from my approach to attempting to value the business. Unlike the speculator, this is the main driver of decisions for the patient investor, who looks at underlying performance over price movement.

Likewise, investing in a business is not like putting cash into a bank account. Business is a difficult endeavour, requiring a combination of skill and luck to generate a return. Some years, the balance will be in the company’s favour and in other years conditions will be such that the company struggles to stand still. Taking this into account it naturally follows that some years, the shares in your portfolio will do well, and others less so, reflecting the underlying performance of the companies you are invested in.

As a patient investor, we must be prepared for these periods of underperformance and paper losses to occur. Although amusing, the social media narrative of panicked faces and exploding emojis encourage many to take a short-term attitude towards markets. Despite protestations to the contrary, these faux ‘long-term investors’ run for the hills after a period of underperformance, and my fear is that they leave their followers holding the bag on an exploded collection of junk shares that they have no idea how to properly value and dispose of.

Instead of following them, take a step back and concentrate on the prospects and performance of the businesses you invest in. Read the annual reports and trading updates – not simply the headlines, but the details. Instead of fixating on price, fixate on the companies themselves. See them for what they are, warts and all, and it becomes a lot easier to value their efforts for years at a time rather than quarter-by-quarter. In short, act as a patient investor.

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