What you need to know about investing during tough cycles
A few pointers about bear markets
After wrapping up 2015 in the financial world, we are dealing with somewhat of a bifurcated stock market. We have sectors like consumer discretionary, entertainment and health care companies rising in price. Then we have what can be legitimately described as bear markets in such core industries as energy, manufacturing and materials.
So which of these areas are we focusing on when we decide to invest new money in portfolios? We are investing more new money into the sectors experiencing the bear markets. Now that might sound counterintuitive. Why would we invest in areas that aren't doing very well?
It all comes down to the price an investor pays for the future value he or she will receive. When you have good news around an industry or a company, you generally have to spend a lot of money to purchase an interest in those businesses. So the price reflects a scenario where things never get worse and only get better.
The investment field has produced many fine research studies illustrating that investing at high prices lowers your odds of good future returns. But investing during periods of lower prices increases your odds. Yet, few investors do it because when you invest during a tough cycle, often the price of the business you own can decline because of the uncertainty in the business cycle.
If you have an opportunity to invest in high-quality, long-term businesses that are experiencing some hard times, these difficult cycles usually open up attractive valuation windows. What we mean by that is you can purchase an ownership interest and a stream of the company's future cash flow for a meaningfully lower price.
If you gauge your investments by how you are doing on a short-term basis (which is how the majority of investors, professional or not, think), you won't move into these opportunities because the short term may not look so good. But if you have the discipline to look long term, then the businesses appear very attractive.
We continue to invest in what we believe are dominant, well-run industrial, energy and materials business through this cycle. For instance, our industrial holdings include businesses that have proven they can make money through a broad range of economic cycles, and we think the odds favor their ability to do so going forward. Yet, we can buy many of them at 20 percent to 40 percent discounts with strong current dividend yields. Thus, we are willing to invest more during these periods with the anticipation that over the next 10 years, we'll be more than fairly rewarded.
We also continue to invest in the businesses that are currently experiencing a more favorable economic tailwind. These are fine businesses; the only problem is we have to pay a higher price to buy new shares in these businesses. It would be great to get the nice tailwinds and the low prices, but it generally doesn't happen like that.
The other larger theme that concerns us is when industrial, manufacturing and commodity business show declines. it often foretells a slowing economic environment. So with the slightly higher odds of a contraction, we'd like to own some businesses that are already priced for a tough cycle, should that be the course the economy takes. And if the larger economy doesn't contract but continues to expand, then it's likely we'll see quicker price appreciation in the businesses we bought at a discount.
Either way, we think there is a good risk/reward scenario for continuing to invest in the core industrial and energy businesses.