Bear Market Investing

Well, we’re having quite a year aren’t we?

UK inflation is now comfortably over 10%, the Bank of England base rate is at 2.25%, the FTSE250 is at 17,250, we’ve had three Prime Ministers, four Chancellors, COVID is still floating around, the war in Ukraine is still grinding on, the pound has fallen further against the dollar, and UK gilts had a rout. Honestly, if I said I had planned for all of this I’d be a bare-faced liar.

My portfolio has taken a beating, being down around 18% for the year, with few glimpses of strength. Years like this are difficult to face – they make you double guess every decision you make – but in the long-term, I believe the last 12-18 months will eventually be looked on as a great opportunity to pick up undervalued companies. Despite this, the overall commentary from economic analysts seems to be that we’re steaming full-speed ahead towards a recession; Goldman Sachs believes the outlook is actually worsening for the UK economy and it hasn’t been a picture of health for quite some time.

The future feels very uncertain right now. There’s no question that inflation is proving more persistent than most experts expected. We’re tightening monetary conditions increasingly rapidly, with interest rates rising and central banks beginning to implement Quantitative Tightening (QT). We’re reversing what has been a long period of relatively easy access to cheap credit. At some point, this is going to have an impact on consumer and market behaviour. We’ve already started to see this in some areas, but until we start to get some more clear and persistent indicators on the trajectory of inflation, it’s hard to be certain about what the future holds.

All of this is leading me to be incredibly cautious with my portfolio. When I look at what most economists are predicting for global growth, it’s slow to negative growth for most of the world in the short-term and red flags being raised around sovereign debt and mortgage affordability as interest rates rise. This environment is not one in which I want to be taking outsized risks with my portfolio. The probabilities are of more headwinds in the immediate future, not less, so I am very much in capital preservation mode right now.

Most of the time, I am fairly optimistic about the future of markets. I believe GDP will continue to grow, companies will continue to innovate and the world will generally continue to grow wealthier over time. As such, my hope is that a recession can be fended off, that global debt doesn’t cause a massive financial crisis and that inflation returns to benign levels.

Despite that, I can hold my hands up and say that I have very little experience of investing in this type of market. For my entire investing career, inflation has been a fear rather than a reality and in terms of serious and prolonged bear markets. Well, markets have been struggling since late 2021 and show no signs of easing. This is by far and away the most volatile and most difficult market I have managed a portfolio in, and it really shows. For most investors my age, the situation will be similar; little experience of these conditions and as such, as a feeling of uncertainty as to how to respond.

So how am I responding?

Well, there are a few fundamental concepts of investing which I’ve been revisiting this year with a view to rebalancing and strengthening my portfolio in a bear market. Firstly, I’ve tried to make sure that my portfolio holds companies with strong returns on capital employed, and by strong, I mean that they consistently earn more than their cost of capital. I tend to use around 8% as my baseline hurdle for companies to beat – if a company can’t generate more than that, I suspect they are likely destroying, rather than creating, shareholder value in the long-term.

Of course, during a recession, the cost of capital usually rises. Interest rates increase, banks charge more for loans, creditors become more stringent, and it becomes more difficult to get cash. This compresses returns for companies and can mean that a firm that was generating a healthy return can suddenly be destroying value for shareholders.

Secondly, I’ve tried to avoid companies with significant leverage – especially of a floating or short-duration profile. companies that require debt to grow are going to find this market almost impossible to navigate. At best, this will mean their growth rate slows but at worse you might find some companies are completely incapable of surviving in these economic conditions. Most recessions are characterised by a spiralling bankruptcy rate and I don’t think the next one is going to be any different. If economists and market commentators are right, and we do enter a recession, I suspect many newer investors are going to be rather surprised by just how weak some big name, popular shares actually are.

Debt is a wonderful thing when times are good and absolute poison to a company when times are bad. A small amount can be paid down and managed to prevent too much damage, but debt generally acts as a serious money sink when interest rates are rising. More and more capital is diverted away from running the company and towards paying the debt burden; employees are laid off, offices shuttered, machinery not replaced, R&D budgets slashed, all to free up cashflow to service the debt.

The way to protect against this is to keep a close eye on how much debt your companies have on their balance sheets. What seemed sustainable 18 months ago may very well become a millstone in a recession if revenues and profits begin to decline and interest rates rise. As an investor, you should be concerned about debt well before it becomes a problem.

For example, around half of the companies in my portfolio are net cash as of their latest results and another third have net gearing of less than 30%. The outliers to this are two financial services companies, M&G and S&U and the telecoms provider, Vodafone. Out of all of my holdings, which three do you you think I’m most concerned about right now?

I’ve also tried to concentrate on companies that return capital to shareholders; preferably through dividends but alternatively through share buybacks. Long-term readers of this site will know that I’m a big fan of income producing assets, particularly companies that pay strong and growing dividends over time.

Finally, I’ve also tried to look for companies with strong, durable franchises; traditionally mid-large cap companies, which have strong track records of success and strong balance sheets. These companies are ‘all-weather’ and have the financial resources to weather significant economic turmoil whilst still growing revenue and profits. They have pricing power, and use that power to protect their margins and maintain a strong and durable customer base. Ideally, these franchises are also in the business of selling goods or services with low cyclicality; things like hospital, leisure and retail are all well off my watch-list as they typically suffer outsized reductions in demand during a recession. After all, when money is tight would you rather heat your home or buy a new watch?

Rather than worrying about when or if we’re going to enter a recession, I accept that I can’t predict the future and simply try to strengthen my portfolio as best I can to weather one if it should arise. I can’t say with any level of certainly if we’re going to enter a recession and if we do how long it will be or exactly what will happen during it. The one thing I am confident about is that regardless of what happens next, I want to be prepared for the worst. So far, my portfolio has taken a beating – I’m down around 18% for the year – but if there is more economic pain to come I want to limit future damage as much as possible while we wait for the markets to settle.

Historically, my performance has been limited on the upside – unlike some retail investors, I haven’t had many multi-baggers or years of return in double digits – but when markets get choppy, I also seem to have managed to limit my downside more. My strong focus on companies with strong economic fundamentals provides my portfolio with resilience – and enables me to sleep well at night, regardless of the chaos in the markets.