Goldilocks, Bears and Canaries

“The farther back you can look, the farther forward you are likely to see” (Winston Churchill).

Lessons from History can often provide useful insights into how stock market investors might behave in the future. The turbulent period leading up to and including the financial crisis of 2007 to 2009 is a good example.

Despite all the handwringing, not to mention the many books and indeed blockbuster movies memorialising that period, there are still useful lessons to be learned and some clues as to the causes of current stock market volatility.

For example, the run on UK bank Northern Rock on 14 September 2007 was expected to herald a massive down turn in the stock market and yet in the following month the FTSE100 index actually finished up 7%. Who could have foreseen such a positive reaction to a massively negative event such as the collapse of a UK Bank?

But exactly one year and one day later Lehman Brothers collapsed and global equity markets plunged. The world economy teetered on the brink of a Depression to rival the Great Depression of 1929-1939. Central Banks rode to the rescue, flooding the financial world with masses of liquidity through Quantitative Easing (QE). Interest rates were reduced to unprecedentedly low levels, in some cases to zero or less. What followed is now history.

The interesting point here is that although Northern Rock later proved to be the “canary in the coal mine”, many investors were not incentivised to heed the warning, preferring to suspend disbelief and stay invested for fear of missing out on further stock market gains (after five years of sharply rising markets).

Perhaps of even greater importance is having the wisdom not to confuse a genuine “canary” with short term market noise, something that is in abundance at the moment. Fear is everywhere; fear of inflation, fear of rising interest rates, fear of the withdrawal of QE, fear of a trade war, fear that the Chinese economy will implode, fears that current stock market valuations are too high. Fear that a Russian or Syrian “Bear” might be the catalyst that destroys the current Goldilocks scenario of not too hot and not too cold synchronised global growth and even, perversely, fear of missing out on the next phase of stock market growth.

But are these fears justified? Could one or more turn out to be genuine canaries in the coal mine, or are they just market noise and a constant wall of worry?

We are often reminded of a Warren Buffet’s aphorism that “Investment is simple but not easy”. Simple in the sense of buying a share in a high-quality business and watching that company compound capital over time. But ‘not easy’ because of the distractions of short-term punditry and the temptations to buy cheap companies of inferior quality, to name but two malign influences.

Clarion do not allow short term noise to knock us off course or destabilise our long term strategy. Nor do we have a fear of missing out on rising stock prices preferring instead to concentrate on risk controls whilst paying careful attention to the warning signs. Watching carefully for the real canary.

In the meantime we continue with our robust fund selection process to guide us towards the best Fund Managers who invest in great companies which can demonstrate consistently high returns on capital thus benefiting from the power of compounding.

Even over a medium term horizon, differences in returns on capital (ROCs) will drive meaningful differences in investment returns. For example, imagine we have two companies trading on 20x earnings:

*Company A—earning 10% ROC and reinvesting 90% of earnings back into the business.

*Company B—also reinvesting 90% of earnings, but only earning a 5% ROC on those investments.

If both companies continue to trade at the same multiple, then at the end of a ten-year holding period the difference in returns will be absolutely staggering. Company A’s investment return will be nearly 9% per annum, compared to a much more modest 5% from that of its peer.

We don’t know when or where the next canary will appear this time around, if indeed it hasn’t already dropped off it’s perch. We remain convinced, however, that profitable companies with strong balance sheets and consistently high returns on capital will prosper in good or bad market conditions, in exactly the same way they have done in the past.

Clarion will continue to search out good fund managers who invest in companies which can generate high returns on capital, knowing that long term rewards will follow for the patient investor who is prepared to look beyond short term noise and not be panicked by canaries and bears in disguise.

This is the best way to create wealth over the longer term.