The first of these is simply overvaluation. Paying too much can mean you will lose money even with healthy business fundamentals. A classic example was Telstra in the technology, media and telecoms boom. In 1999, Telstra traded on a forward price to earnings ratio of more than 30 times with the share price reaching $8. For the next five years, Telstra’s earnings per share grew at a steady mid-single digit pace, the business was doing fine, but this didn’t stop the share price more than halving.
Equity dilution
The second source of permanent capital-loss risk comes from an overly geared capital structure leading to extensive equity dilution. Mirvac before the global financial crisis is a good example. In 2017-18, Mirvac made operating earnings of $807 million which was a good 60 per cent higher than the $491 million earned in 2006-07. Despite this large increase in earnings, Mirvac’s share price today is about $2.30, which is less than half the $5 to $6 share price range seen during 2007.
The key reason for this divergence between earnings and share price is the more than tripling of shares on issue, from 1.2 billion shares in 2007 to 3.7 billion shares today. Too much debt in the lead-up to the GFC meant shareholders were not able to ride out the cycle and benefit from the eventual recovery in earnings.
Structural change
The third source of permanent capital loss is probably the easiest to understand, structural change or the death of business models. Here we can trot out the well-known examples of Kodak, newspapers and department stores. This risk is ever present but the stress of a negative market or weak economy can accelerate structural change and bring forward a day of reckoning.
Avoiding permanent capital loss will allow your portfolio to ride out a potential downdraft and maintain your capital by participating in the eventual recovery. But we can do better than merely defending. Downturns provide fantastic opportunities to buy shares. This is obviously true but is not very helpful. How do you know the downturn has gone far enough?
Buy signal
Firstly, don’t try to time or pick a precise bottom in markets. Secondly, don’t use the economy as your trigger to buy. Despite the never-ending economic commentary explaining rises and falls in equity markets, you might be surprised to know that economic growth has a very low correlation with equity returns.
So if not the economy, what should you be looking for as a buy signal in a downturn? Valuation.
As my colleague Philipp Hofflin has demonstrated using Australian data back to the 1960s, about 80 per cent of the market’s subsequent 10-year return is determined by the starting CAPE ratio (this is the market’s P/E using the previous 10 years average earnings adjusted for inflation). Valuation provides a weak signal on a one- to three-year horizon, but as you approach a decade or more it is pretty much all that matters.
So for 2019, beware permanent capital loss by avoiding overvalued stocks, balance sheets with equity dilution risk and business models that are severely challenged to protect your portfolio. And pay attention to valuations so you can buy at attractive levels to turbo-charge returns for the decade to come.
Aaron Binsted is a portfolio manager at Lazard Asset Management
from Just News Viral http://bit.ly/2RsrkL2
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