How to invest in a mature bull market


  • Business
  • Saturday, 16 Apr 2016

THE FTSE Bursa Malaysia KLCI (FBM KLCI) together with the Dow Jones and all major indexes have been bullish over the last seven years. Since the 2008 subprime crisis in the US, markets have been on a virtual uptrend right up to now. It hasn’t quite ended, and here lies the skittishness.

After the seven-year run, most investors are getting nervous. Is this uptrend going to continue or is an impending correction just around the corner?

Investors are in a flux wondering where the market is heading. They wonder how all the data we see today, like indicators of a sluggish economic outlook, falling earnings and currencies, slowing growth in China, negative interest rates, and staid yields will ultimately affect market performance.

Since the start of the year, markets have behaved in a more volatile manner. Some steam and breadth have been lost. Not surprising as these are things that happen at the second half of a bull market cycle.

A seven-year old bull is certainly mature.


So does the strategy of buying stocks change during this mature bull market period?

StarBizWeek looks at some of the strategies to undertake when faced with this particular market segment.

A mature bull market doesn’t necessarily mean we need to sell out and hold on to cash.

Human beings have a natural tendency to fear heights. While this natural survival instinct works well in the wilderness, it plays against us when it comes to the stock market.

Why? Simply because we tend to sell out too early and miss out on the fatter gains which come with a higher price.

There is still a way to make money and stay invested during a maturing bull market cycle. Of course that strategy will be far different from investing in a young bull cycle.

Chen: ‘Our cautious expectations have not changed despite the recent market rally.’
Chen: ‘Our cautious expectations have not changed despite the recent market rally.’ 

Eastspring Investments Bhd chief investment officer Chen Fan Fai says he is relatively cautious as he expects a challenging environment for the Malaysian economy in 2016, although global liquidity has given the big cap stocks in the Malaysian market a boost.

“Our cautious expectations have not changed despite the recent market rally, which may have been more from the changes in foreign fund flows, stronger ringgit and a positive bounce in crude oil prices. This positive sentiment may not be sustainable given the supply of oil is still an issue, the US is still expected to hike rates in the second half of 2016, and the continued weak Malaysian consumer sentiment persists,” says Chen.

He adds that stock valuations currently look peakish – as would normally be the case when markets have trended up without follow through upgrades in earnings outlook.

Invest in the big caps

Monem Salam, president of Kuala Lumpur-based Saturna Sdn Bhd, a subsidiary of US-based Saturna Capital, says he never advocates investors to hold all cash because one never knows when the market will go back up when it starts going down.

“We like large cap companies which offer some growth – the types of companies that have strong balance sheets and give good dividends,” he says. “Even better if they have a history of increasing dividends.”

“A strong balance sheet means they will be able to survive any economic downturn. Also, as the economy becomes more challenging and some of the weaker companies start to fall, these bigger cap companies have the financial muscle to buy these companies,” Monem explains.

Monem: ‘We like large cap companies which offer some growth.’
Monem: ‘We like large cap companies which offer some growth.’ 

He adds that another indicator he looks at for these big caps is the return on equity that the company is offering.

“Our stance has always been based on bottoms-up stock selection, and whatever the cycle, we always continue to monitor companies that have sound business models, good corporate governance, strong balance sheets, so that any correction in the market would serve as an opportunity to accumulate these fundamentally strong stocks on weakness,” said Chen.

He added that the small and mid-cap stocks have done tremendously well against the big caps, but that part of the market is pretty crowded now.

“The bull cycle is already quite long and the valuation gap between the small and big caps has narrowed a lot. Another point to note is smaller companies are generally more vulnerable to economic headwinds,” said Chen.

Early stages of bull markets tend to be led by small cap value stocks, and by virtue of there being more small cap stocks in a market capitalisation weighted index, this means that a larger percentage of stocks outperform the broad market.

The portion of stocks outperforming the overall market is known as market breadth.

According to Fisher MarketMinder Investments, lower valuation, capital intensive firms also tend to lead in the initial bull market rally. This is seen in the V-shaped surge – hence small cap value’s tendency to lead early on.

However, as the bull market matures, investors begin to focus on the smaller number of high quality big cap growth stocks. This is seen in two main ways – firstly market breadth starts falling. Secondly, big cap growth stocks start outperforming small cap value stocks.

Fisher Marketminder explains that small value companies tend to be concentrated in mature, commoditised industries leveraged to the most cyclical segments of the economy. These firms may also be capital intensive, leading to heavy dependence on debt financing. As such, a steepening yield curve (strong incentive for banks to extend financing) and pent-up capex tend to form an ideal backdrop for small value outperformance. And those two features tend to be classic characteristics of early expansion.

In contrast, big growth sectors are generally less cyclical and less capital intensive. Growth is often driven by innovation, new product development and rising market penetration (as the markets aren’t as mature). And they are typically less reliant on debt financing. Hence, as the yield curve flattens, that tends to favour big cap growth more and small cap value less.

Small cap’s returns are largely a function of the market cycle. Small firms usually get hammered in bear markets and cut costs to the bone in order to survive. This gives them an easy base for earnings growth when the bull begins – even modest revenue recovery brings big earnings gain.

This, along with the reversal of the extremely dour pessimism surrounding small caps in the bear market’s final leg (a period when people worry about the small firms’ survival) gives small caps a further boost during a new bull.

The chart shows small cap and large cap returns during the first year of every new bull market since 1926. During those 13 years, small cap’s annualised return is 26.25 percentage points ahead of large cap. The rest of the time, small cap’s annualised return is nearly 1.4 percentage points behind large cap.

Stocks with fat gross margins and cash flows

Ambrose: ‘We like companies with cash and have good cashflow whatever the economic conditions may be.’
Ambrose: ‘We like companies with cash and have good cashflow whatever the economic conditions may be.’ 

Aberdeen Asset Management Sdn Bhd managing director Gerald Ambrose says to “keep calm and focus on cashflow”.

“We like companies with cash and have good cashflow whatever the economic conditions may be. We like companies that have a moat built around it. They have asset values which far exceed their share price,” he says.

“I like Panasonic Corp Bhd. Even if I were to burn down its factory, the value claimed from the insurance would still exceed its stock price value,” he adds.

Ken Fisher in his book Beat the Crowd says stocks with fat gross margins offer a firm more discretion to fine-tune its future. It allows them to invest in more research than peers do. Or market more. Or afford more capital expenditure. It renders more reliable future earnings – the very theme that later-stage bull markets love.

Fisher says gross margins have big power. If a firm has thin margins, it will probably do best early on in a bull market. Thin-margin firms get punished in bear markets when investors fear they don’t have enough of a cushion to survive. They are usually over punished, so they’re over-rewarded when stocks bounce and thin-margin firms bounce bigger.

Later on, in the back half of a bull market, investors get choosier and want firms with more stable earnings, growth and more ability to fund growth past any potential upcoming recession.

This is when stocks with fat gross margins shine. This is because the bigger a firm’s margins, the more resources it has to ensure its future, invest in more research to fund the next cutting edge, afford more capital expenditure to boost production – expand, upgrade, you name it.

“All of these make future earnings more reliable, which markets love as a bull market wears on and fear of heights takes hold and new buyers, previously too fearful for stocks, start dipping their toes in the bull markets warming waters,” says Fisher.

Diversified revenue

Warren Buffett once said that “diversification is protection against ignorance”.

At the end of the bull market, when risk aversion has increased, the primary goal is to protect one’s returns rather than to maximise returns.

This is where investing in a company which has diversified returns helps. The goal here is to limit the impact of volatility on the investor’s portfolio.

Foong: ‘Companies with diversified revenue are often chided as being too much of a mixed bag for many investors’ palates.’
Foong: ‘Companies with diversified revenue are often chided as being too much of a mixed bag for many investors’ palates.’ 

Sherilyn Foong, director of investment banking at MIDF Investment Bank, says stock selection is everything in a maturing bull market.

“Companies with diversified revenue are often chided as being too much of a mixed bag for many investors’ palates. Because of that, these stocks always trade at a discount to their sum-of-parts valuation. Nonetheless, in the current uncertain global and domestic environment, the diversifieds will provide some defence mechanism to the investors portfolio,” says Sherilyn Foong, director of investment banking at MIDF Investment Bank.

Chen said that going overseas will give fund managers a wider choice and more opportunities to generate higher returns for investors in the long term.

“If your investment horizon is three to five years, regional funds would be preferred over single country funds such as Malaysia. Currently there are cheaper markets in terms of valuations, especially in North East Asia,” said Chen.

“Besides the fact that investing abroad provides you more opportunities in the long run, you are also able to diversify across economies at different phase of their cycle, including exposure to various underlying currencies. Diversification should be one of the main tenets of any investor,” said Chen.

Certainly, a company with a diverse revenue base spreads out exposure to market sell-offs and poor business conditions.

“We may have loved oil and gas stocks. But if our portfolio was only filled with them last year, we would have taken a major beating and significantly underperformed the market in general last year and this year. The same can be said about banking stocks during the 2008 US financial crisis and the technology sector in 2000,” says one dealer,

Chen thinks that monetary policy has almost run its course.

“You can only pump so much money into the system and bring interest rates down so much. To further stimulate the economy, fiscal stimulus in the form of spending or incentives may prove more effective and immediate in their outcome. Thus, when investing in the region, you want to be looking at the sectors that are likely to benefit from government fiscal spending or incentives programs,” he said.

Simple businesses

This may sound basic, but in all honesty, most investors buy stocks they don’t quite understand.

Value investor Warren Buffett has told shareholders many times that Berkshire Hathaway will only buy into businesses that the directors understand.

“We try to stick to businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change we’re not smart enough to predict future cash flows. Incidentally that shortcoming doesn’t bother us,” Buffett was once quoted during an interview.

A simple business to understand is Coca Cola, for example. Coke is the world’s largest beverage company, making and distributing worldwide such products as Coke, Fanta, Sprite, Evian and Minute Maid. It has been in business many, many years and is perhaps the world’s most recognised brand name.

Now take a company like General Electric with its complex business structure and multiple business segments.

It has diversified infrastructure and is a financial services company. The products and services of the company range from aircraft engines, power generation, oil and gas production equipment, and household appliances to medical imaging, business and consumer financing and industrial products.

While the businesses are obviously good, the complex structure of the company makes it hard for the average investor to understand its business and financial position.

On the Malaysian front, Foong likes home-grown champions that can hold their own on the global arena, and this includes the gloves and plantation players.

“Within these sectors, the small to mid stock cap space provides unpolished gems and opportunities to significantly outperform the Index on an absolute and relative basis. Our local champion companies with their strong niches will shine, such as those with market presence and strong brand names in the consumer, export and food manufacturing sectors,” says Foong.

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