Investors have become conditioned to “buy the dip” in recent years. Every small set back in markets has been a buying opportunity, largely on the back of central bank support. Every time markets fall a central bank official, at the least, issues some soothing word store as sure nervous markets, and this week has been no different. The question is should we be buying this dip as well?
To answer the question we need to put the setback in context. Despite some of the dramatic headlines, valuation levels remain very elevated. Given that valuations are the main driver of future returns, the recent changes in price have by no means presented a mouth-watering buying opportunity.
Local market PE – stll expensive
World markets – no slam dunk
Even though we manage client portfolios on a bespoke basis, our investment goal is the same across portfolios. We aim to compound long-term wealth by providing above average returns at below average risk. We try and do this by patiently building a portfolio of companies that exhibit the following three simple characteristics:
- Good business
- Good price
- Good management
Despite the sell-off, there are not enough companies that meet our criteria for “good price”. As a result we do not view this as a great buying opportunity, particularly in the domestic market. We do view it as an opportunity to continue to accumulate stakes in good businesses that were already trading at a discount, but where that discount has now widened (i.e. a good price has become a great price).
One such business is Imperial Holdings, a company which we own and have added to in the sell-off. Imperial is not a great business, but we are of the view that it is a good and improving business, has exceptional management and, most importantly, trades at a very good price. During the company results presentation this week, CEO Mark Lamberti made a very interesting point. He commented that “the 2nd and 3rd order effects of a response to slowing Chinese growth have yet to be fully understood”.
In my view this is a critical point and one that requires a great deal of thought. Thus far the market has only priced in the 1st order effects of slowing growth in China, largely through the pricing of commodities and emerging market assets and currencies. While our market has held up better than most because of the make-up of the index, other emerging markets have seen very sharp declines.
If the scale of some of these price changes in the most cyclical assets are to be believed, I find it difficult to imagine how the knock on effects for other industries and companies will be as muted as the market is implying. As a result we are very wary about paying up for anything at the moment. Buying at the right price is more important now than ever.
A more uncertain market environment is certainly challenging, particularly given the easy ride investors have had in recent years. It is likely that at some stage the same complacent investors who have confidently been buying the dip for the past few years will lose their nerve. Portfolios that offer lower than average prospective returns at higher than average risk will start to be questioned. We welcome any decline in sentiment and are ready and waiting to continue to add to our stakes in companies that are already undervalued, regardless of the macro environment.
So to answer the original question – no, we do not think one should be blindly buying the dip, but rather continue to selectively accumulate, but to do so with caution!