Patience is crucial, even if you own more defensive-type stocks, such as utilities; real estate investment trusts (REITs); or stocks in a sector that are often less challenged by market cycles, like consumer staples. Over time, if money crowds into stocks like these and everything else sells off, value investors can step in to buy more attractively priced stocks “on sale.” What’s more, when defensive stocks finally correct, they often end up in the same place as everything else – near their median price.
Buying the right stock
Investors can’t just buy the right sector, they must buy the right company. A safe sector doesn’t exist. In the current market environment, excesses that have built up over time – including excessive valuations – are being ironed out. This is sometimes referred to as the bursting of the “everything bubble.” Opportunities exist, but they are security, not sector, specific.
It is essential to look at where a company is in its supply chain, its balance sheet, and what its management is doing. It is important to ask whether a company is a good steward of capital and its assets. It is best to avoid companies that are over-levered and have top-line problems and therefore may have a margin problem down the road.
At Vaughan Nelson, we recognized liquidity tightening back in September 2018. We documented a list of companies we wanted to buy in a correction that included both new companies and companies we held and looked to increase ownership of. We also assigned price targets to a short list of stocks.
We made use of market volatility during the fourth quarter by picking off individual securities we believed were available at a value that have the ability to meet our three-year targeted return expectation in an incrementally more challenging environment for the broad stock universe.
Sifting through bad apples
Most companies today have one of four problems: a valuation issue, slowing revenue, margin pressure, or excess leverage. Businesses that check all four boxes are the easy ones to cross off a list of potential investments. But if a company has issues, what’s the least worst situation? How do you begin to build portfolio positions if everything has a little bit of hair on it?
Every company will have at least one of these challenges. Frankly, most companies have a valuation problem, some material and some not material. That is the case even for a good company with a clean balance sheet, great margins, great growth – if the rest of the market sells off, eventually it becomes advantageous for investors to sell that company’s stock and go buy another stock that has sold off even more.
It is important to evaluate the opportunity set, as well as what the market has been doing. Some areas of the market with all four of these issues have sold off enough that the valuation problem is almost completely fixed. In the small-cap space – which is a little more cyclical than the broader stock universe – it can come down to a tradeoff between revenue growth being a little lighter or margins being a bit lighter.
At the end of the day, there is no place to hide. It’s a question of when things re-price and whether a company has sufficient time to grow earnings so that any re-pricing is relatively immaterial. Sometimes, stocks with the most hair on them actually turn out to be the best opportunities.
Don’t go into an investment blind. Recognize the tradeoffs. Don’t sacrifice return criteria. Liquidity won’t always be there, but that can be your friend or your foe. It all depends on what you own.
This material is provided for informational purposes only and should not be construed as investment advice.