Why making money from shares just got a lot trickier

Why making money from shares just got a lot trickier
Warren Buffett argues that consistent investment in high quality companies, through thick and thin, pays off handsomely long-term

The Irish Stock Exchange Index — the Iseq — is ending the year in a sorry state.

While the overall economy has boomed during 2018, the stock market has endured a torrid 12 months during which its overall value has declined by more than 20%.

At an individual company level the damage has been even more pronounced.

Large profitable companies have suffered share price declines that are more representative of a full-blown bear market.

Bank of Ireland’s share price is down by around 30%, while AIB has fallen over 30%.

The global construction company CRH has seen its share price fall 24% while Ryanair is down by more than 30% and the gaming group Paddy Power Betfair is 28% weaker.

These large declines are driven by a number of factors specific to individual sectors and also issues related to global equity market sentiment.

In airlines, for example, concerns about excessive capacity increases and related intense competition has worried investors about revenue trends.

Banks have been afflicted by falling share prices in the institutions across Europe.

Property companies have been affected by sharp falls in comparable companies in the UK that raise valuation debates for those in Ireland, despite the latter operating in much stronger economic conditions.

Alongside the sector specific matters, a broader set of concerns has descended on equities in general.

Some of this relates to valuation multiples that were pumped up since 2010 due to looser monetary policy worldwide.

As Central Banks opened the taps on money flow so-called risk-free assets delivered returns close to zero.

That, in turn, drove demand for equities and pushed them to profit multiples that have been rarely seen in history.

As the quantitative easing (QE) process has unwound multiples are reverting to more long-term averages.

This has created frustrations for both investors and company directors as they have largely not changed their guidance on earnings or profits, yet their share prices have fallen by double-digit percentages.

Behind those shifting valuation multiples there are also growing concerns about the trajectory of global economic growth, with a particular focus on momentum in North America.

After the turbo boost of tax cuts last year the US economy is veering towards slower year-on-year growth.

Rumblings, too, about the absolute level of debt stacking up in the US is a concern for economic performance beyond 2019.

Equity investors tend to look at multi-year profit and earnings projections, so adverse economic forecasts affect their confidence. This is flowing through equity market sentiment, currently, and helps explain why broader markets are suffering.

On top of that, the entire Brexit palaver is creating fear and uncertainty for any investor or company exposed to the UK economy. This, too, is undermining confidence among investors concerned about developments in 2019.

A client of ours pointed out an interesting correlation between a measure of global money flows – M1 – and a proxy for economic activity.

Since 1989 the two have behaved like twins, rising and falling as the global economy grew and contracted through 9/11, the global financial crisis and other external shocks.

Since late this past summer the M1 measure has started to fall sharply yet the manufacturing PMI index has remained steady.

The money measure may be connected to global central banks withdrawing QE emergency liquidity measures.

Whatever the cause, that M1 measure will, based on the historic correlations, drag down the global economy.

This could be what equity markets are telling us, particularly in the US where a marked sell-off has been evident since October.

Repeatedly, over the last 30 years, we have seen periods when equity markets shift downwards and the temptation is to avoid equities or sell out of positions that are under water.

Warren Buffett is good on this subject, as he argues consistent investment in high quality companies, through thick and thin, pays off handsomely over the long-term.

Dollar average investing is the term used to describe regular investments in company shares that ignore the volatility of equity markets and instead focuses on whether or not the reasons you chose to invest originally has changed or not.

If the inputs you used to invest – quality management, well-positioned business models, evidence of consistent growth in good and bad times, low valuations – are still intact, then adding more investment will help build real value over the long-term.

This all sounds great in theory, but personally I like to have the comfort of regular reliable cash dividends to keep me relaxed as equity markets swing about.

To that end, your portfolio should be peppered with companies that have solid dividends that have grown over time and are well covered by profits, even during tough economic conditions.

These companies often deliver higher dividend yields in weak equity markets as share prices decline and that is very clearly a pattern at present.

For a number of years it has been extremely difficult to find companies that are paying dividend yields of 4%, or above, because equity markets were elevated by QE, which pushed global interest rates to all-time lows.

That is now unwinding and leaves a wide number of companies that are paying good yields.

The hunt for safe income requires diligent analysis. Those companies with dividend policies explain them clearly, and detail their track records in paying them.

Good companies grow those dividends at rates in excess of inflation without compromising the integrity of their finances.

Business models that have competitive advantage and adopt measured financial risk in borrowings can produce sufficient cashflows to pay dividends while re-investing in their operations.

The really good ones also create true equity value by generating returns on capital employed that exceed the cost of that capital.

As we approach 2019 equity investors have to grapple with heightened concerns about global economic activity, lower valuation multiples and a tough stock market performance during 2018, particularly in the second six months.

It requires bravery to commit money to equities at times like this but equally buying only when all appears rosy, as was the case a year or two ago, is short-sighted.

Building an equity portfolio takes time, patience and an appetite for risk.

For a number of years since 2010 the challenge has seemed as easy as falling off a log but now the more testing times have arrived.

It is those who can navigate these very choppy waters who will fare best over the coming decade.

Joe Gill is director of corporate broking with Goodbody Stockbrokers. His views are personal.

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