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Markets have crashed - should investors buy or sell?

by Francois Joubert, Analyst, Red Hot Penny Shares, 22 July 2022
Markets have crashed - should investors buy or sell?
Over the past six months the JSE All Share index dropped over 11% on average.

The JSE's Resources index is down a whopping 28% for the same period.

Does this mean the losses are permanent? Should you be selling your stocks? Or does it show us an opportunity?
The stock market is volatile – but that shouldn’t worry you too much

When stock markets drop, like they just have – it is due to volatility.

All stocks are at risk of volatility – that’s how their prices rise and fall.

The main stream financial industry uses volatility as a measure of risk. Small cap companies that are more volatile with fast rising and falling prices are highly risky, while blue chip stocks with steadier rising and falling prices are ‘less risky’.

But the fact is, volatility is merely the short to medium term trends we see on markets.

War, inflation, supply chain problems etc have caused volatility in recent months – and markets have dropped.

But that certainly doesn’t mean the drop is permanent.

An end to the war, interest rates bringing inflation under control, will see markets stabilise, and eventually rise again.

Equity markets experience three to four declines of 5% a year, one decline of more than 10% a year, and one decline of 20%+ every three to four years on average.

Predicting when these declines begin and end has proven to be a “loser’s game.” Equity investors get rewarded by not excessively stressing about price volatility and holding on to solid stocks through tough times.

But that brings me to the kind of losses you should be worried about….

The losses you should be worried about are the kind where a stock drops in price – permanently.

We talk about permanent loss of capital.

There are a couple of different forms of permanent loss of capital you should be aware of:

•    Permanent loss of capital due to fraud or a massive adverse event
Think about the Steinhoff saga. It surfaced that the company was defrauding investors through lying on its financials for years. The share price crashed. It is down 96% in the past five years. Sure – from here there might be some upside again one day. But the drop from its +-R100 share price level to less than R10 is more or less permanent. The capital is gone, investors have lost. The business no longer has the assets to generate enough returns for its share price to recover. Similarly a mining company might have a massive tailings dam rupture, which destroys its mine, and opens it up to law suits. This could destroy a company, and in this case there’s very little way to foresee the event.

•    Too highly priced growth stocks
We all want to invest in the next big thing. Tesla, Netflix, Curro were all shares shooting through the roof for years with 1000% gains for investors.

But seldom do stocks on 100, 200 or 500 PE ratios end well.

Simply put – it has nothing to do with their business, but all to do with investor expectations.

If I use Curro for instance, great company, great growth trajectory.  Between July 2012 and January 2016 the stock rose from R12 to R57.80. But investors were paying for growth the company would only realise in one or two decades time.

So the slightest underperformance in growth meant the stock would fall. And that happened. Eventually investors realised even with 30, 40% growth every single year the company would still look expensive in ten years’ time at R60 a share…

The share price crashed down to a low of R5. This is more or less a permanent loss of capital. Never again will Curro trade at a PE ratio of 100+ sustainably. And based on current growth rates it will take eight to ten years for the stock to hit R60 a share.

•    A business model goes obsolete or a moat disappears
Sometimes a company is priced at a high level – and then crashes down because the entire business case for it is invalidated.

Imagine the case of Kodak – the company produced cameras and nearly all the film for film cameras for the entire world. Today’s youth probably haven’t ever seen a film camera!

This saw Kodak’s share price crash from nearly $40 in 2014 to $2 in 2020. The losses are more or less permanent – as the company will never again regain the monopoly it had before. Digital cameras replaced film – and Kodak didn’t keep up with the times. Many say this is what will happen to oil producers in coming decades.

Avoiding these kind of losses is more important than most other aspects of investing. Share prices fall, but the majority rise again as well. If you can just avoid the catastrophic losses – you’ll be more than ok.

That means you need to look for companies with good cashflows (more important than good profits), sustainable debt levels and good management teams. Avoid overpaying for companies, and always look at the company’s business model and possible threats to its existence in coming years due to changes in technology or big changes in consumer behaviour.

Here’s to unleashing real value

PS.  My five top stocks to buy now have all the qualities I describe above, you can get the details on these five here.

 
 

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Markets have crashed - should investors buy or sell?
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