“The rain fell, and the floods came, and the winds blew and beat on that house, but it did not fall, because it had been founded on the rock.” Matthew 7:24-27

Market drawdowns stir up very different emotions. Some investors get excited about the prospect of buying the dip. Others get scared into selling because they don’t want to watch the holdings in their account fall any more.

These two groups sound very different. But they share something important in common: the urge to act. To do something – anything – to feel more in control or feel like they are taking advantage of the conditions.

This probably stems from some kind of belief that “this is it”, a generational market event that you must do something about either way.

I don’t know if the recent sell-off will develop into something generational. Markets have stabilised since last week, and nobody knows or has ever known what markets are going to do next anyway. Shifting your portfolio around based purely on a prediction of where they are going to go, then, is a coin flip.

It is every bit as likely to harm your results than help them.

Focus on what you can control

This recent period of volatility – as with every other period of volatility – is one in which you should focus on controlling what you can control.

At the highest level, that means having a strategy to reach your goals. One layer down, it means making sure your allocation between asset classes suits the returns you need to achieve that goal. Go another layer deeper and it means owning investments that align with your goals and that you are comfortable holding long enough to get there.

The whole “be fearful when others are greedy, and greedy when others are fearful” thing doesn’t work if your approach changes based on what the financial media suggests you should be feeling on any given day. You need to have a strategy in place before things get wild. That way you can be in a better place to act more rationally when they do.

Prevention is easier than the cure

My goal here is to help you form a portfolio that you are less worried about in the next downturn.

I say this because you don’t want to be worrying about your existing holdings at times like this. You want to be able to carry on pretty much as normal. You want to be researching potential investments, finding ones that align with your strategy, and working out what price would make them attractive purchases.

A downturn might provide you with such a price. But if you are too busy worrying about your existing holdings, you might not notice. Prevention is easier than the cure here. By that I mean it’s better to make sure that any purchases meet solid panic-busting criteria in the first place.

Here are four criteria that I apply to purchases for my own stock portfolio. I think they helped me maintain a fairly zen-like state despite last week's volatility. Maybe they can help you too.

1. High quality business with a fair long-term outlook

Will the product or service provided by the company still be required in ten years? And does the company have a durable advantage in selling their wares profitably?

A couple of examples:

  • People will still be trading shares and other securities in ten years. In my opinion, it is highly likely that the leading security exchanges in ten years will be the same ones with dominant positions in their asset class today. These businesses benefit from network effects that make it very hard for a new entrant to unseat them. You can read more about network effects here.
  • Unfortunately, people will still be getting sick and suffering from illnesses in ten years’ time. In my opinion, it is likely that today’s pharma and biotech majors will be selling many of the latest treatments at that time. Most likely with patent-protected levels of profitability. This is because I think their expertise, strong cash flows and embedded sales teams give them an edge when it comes to finding and commercialising new drugs.

If I am confident that a business will still be in a position to generate attractive profits for me as a shareholder for several years from now, day to day movements in its stock price seem rather irrelevant.

2. Companies that can survive (and benefit from) bad times

I would not want to own a company where I was scared that an economic downturn could send them out of business. What I’d ideally have is a company with a strong enough financial position to survive and emerge stronger from any industry or market downturns.

This could mean being able to increase marketing spend to win share as more vulnerable competitors cut back. It could mean continuing to invest in product improvements while others can’t. It could be a structural ability to withstand lower prices due to a cost advantaged position.

This could also involve buying a distressed competitor or making other investments (including share repurchases) at attractive prices. Obviously, having a management team that has exhibited sound capital allocation in the past boosts my confidence. You can read Shani’s article about the importance of capital allocation here.

3. Reasonable valuation at time of purchase

“In the short term, the market is a voting machine but in the long-term it is a weighing machine” Benjamin Graham

Stock market valuations overshoot both ways but will eventually get it roughly right.

Over time, the three main sources of a stock’s return are growth, dividends and changes in the valuation multiple. In the absence of remarkable growth, entering a stock position at an obscenely high valuation leaves you vulnerable to a down draft.

For example, if everything else stays the same but the market suddenly decides it wants to pay 30x earnings for shares you bought at 40x, that is a 25% headwind for the stock. I would rather have valuation as a tailwind at the time of purchase.

If I bought a stock without worrying about the valuation first, I am almost certain that I would become very worried about it later and become more likely to act on emotions. This is exactly the kind of behaviour I am trying to avoid. You can see Mark’s checklist on how to think about stock valuations here.

4. Companies that meet your investing strategy

“Know what you own and why you own it” Peter Lynch

The above quote from Peter Lynch is usually taken to mean why you think a business can do well and its stock can go up.

I don’t think that is a bad way to view it – it encourages you to look at the stock as an ownership interest in a living business rather than a just a daily market quote. I think the quote is even more valuable, though, when it frames individual holdings in the context of your goal, strategy and selection criteria.

Being able to say “I own X because it is likely to see continued demand for its products and services over time, has competitive advantages in its key segments and has a strong financial position” is more likely to keep you sane than “I own X because I think it can grow earnings at 15% per year and reach my target of $100 per share in 2 years”.

Your criteria are subjective in both cases. But the first set of criteria depend on your view of facts related to the business – facts that are rather slow moving and can be analysed without constant market noise. This is very different to basing your "why" on predictions that are completely out of your control (and more subject to mood swings).

So, these are four panic-busting qualities I look for in stock holdings:

• High quality business with a fair long-term outlook
• Companies able to withstand and even benefit from tougher times
• Valuation more likely to be a tailwind than a headwind in the long-term
• Companies that meet my investing strategy

I think that point four is most important.

Making sure you have a strategy in place gives you guiderails that lead to more deliberate decisions rather than ones based on emotion. In other words, you are building your approach to investing on rock, not sand. Go here to read Mark LaMonica’s step-by-step guide to crafting an investing strategy.

 

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