Learn to Love Sharemarket Falls

Most people are net buyers of stocks throughout their lives, which means that market falls should be welcomed rather than feared.

It has been quite a ride for financial markets since August of last year. After the word "subprime" entered the vernacular in that month, the initial selloff was followed up by an even more impressive rally, culminating in the record ASX highs of early November. Reality bit though, over the end of the year, and despite a sharp recovery from recent lows, it may not be all over just yet. A looming US recession plus fears of more finance sector write-downs and domestic rate hikes, have seen the local bourse drift lower.

The truth is that fear and panic get people's attention and the media is well aware of it. But it's at times like this that investors need to stand back from the crowd and make a cold assessment of what's going on. No doubt some companies are affected by recent turmoil in global debt markets, but some have, and/or will generate, all the cash they need for their future investing plans and have little to fear from a recession, which might in fact help them take market share from competitors. Yet these companies have been getting cheaper along with everything else and we've been licking our lips.

It's a truism to say that, all things being equal, you'll do better from stocks if you buy them cheaply. But what people forget is that for most of their lives, they're net buyers, or at least holders, of stocks. And the ideal situation is to reach retirement with enough in your pot that you never have to become a net seller. So for most people, for most of their lives, stockmarket falls are a good thing.

Price and value

The crucial point to understand is that the price of a stock and its value are two different things. The market sets the former and our job as analysts is to spend our days trying to estimate the latter. To make our life easier, we generally avoid poorly managed, debt-laden or cyclical businesses where predictability is poor, and we look for a margin of safety to protect us against an error of judgement - the more uncertain we are about a company's value, the greater the margin of safety we require.

Most of the time, price is pretty close to value. But sometimes it gets out of whack, and occasionally by enough to give us a decent margin of safety. It's these situations that present the greatest opportunities for canny investors and the greatest dangers for those who succumb to understandable but irrational mood swings. Preparedness makes all the difference.

Imagine you're researching a company, Little Acorn Limited, which operates in a predictable industry, has decent management and pays no dividends. It reinvests all its profits, meaning that returns are entirely in the form of capital growth. You've done the work, and are as comfortable as you can be that Little Acorn will grow earnings per share (EPS) at 10% per year, from the current level of $1.00, with very little chance of variability.

Deeming Little Acorn to have all the right stuff, you buy the stock for $15 - a price-to-earnings ratio of 15. If your estimate of earnings growth is accurate, then EPS will grow from $1.00 to $2.59 over the next decade. If the market is still happy to pay a PER of 15 at that point, then the stock will trade at around $38.85, and you'll have achieved an annual return of 10%, in line with the earnings growth.

The future is always uncertain

Of course, the stock might trade lower in a pessimistic market in 2017, giving you a lower annual return (but an underpriced stock that's likely to do well in future years). Alternatively, it might trade higher, giving you a larger annual return (but an overpriced stock that you might choose to sell).

Which of those possibilities eventuates is of some importance. But what happens in the stockmarket over the next week, month or year doesn't make a lick of difference as to how the market will view Little Acorn in ten years' time.

So let's say that shortly after purchasing Little Acorn for $15, the market tanks and takes Little Acorn with it - down to $8. The talking heads everywhere go berserk over the 'blood in the streets' and you're staring at a 'loss' of almost 50%. The emotional investor gets the chance to do some real and permanent damage here, by panicking and selling up, at or near the lows. Avoid this at all costs.

Assuming that Little Acorn is still as likely as ever to grow its EPS at 10% per year and arrive in 2017 with EPS of $2.59 and a stock price of $38.85, your forecast of its future is unchanged, and your expected return from yesterday's investment is unchanged at 10% per year. You won't get that return if you sell out now. But if you do nothing but hold, your eventual wealth will be just as great as if the share price followed a straight line from $15 to $38.85 over the course of a decade.

But wait, there's more

If you have some spare cash though, you can actually improve your position, by going against the crowd and buying more shares in Little Acorn at $8. At that price, your additional investment will compound at 17% per year until the shares trade at $38.85 in 2017, dragging up your average return in the process. So the market tumble has actually provided an opportunity.

Of course, the real world isn't so neat. Market crashes can hurt the economy, affecting company profits in the short and medium term. And the 2017 value of the stock will swing based on both the mood of the markets then, and the company's growth in the intervening years. But that's the case regardless of whether stocks are cheap or expensive today. Which brings us back to the trusim that the less we pay for our stocks, the greater the bargains they'll prove to be.

So remember that when the market takes a tumble, it's just changing the price that it's setting for stocks. The value of those stocks, all things being equal, will remain the same. You don't have to sell your stocks, but you can choose to buy, if you have the spare cash and can find something suitable. Viewed like this, market crashes won't do any harm to long-term investors, but actually offer you the chance to compound your money at a greater rate.

Gareth Brown
Senior Analyst
The Intelligent Investor

See www.intelligentinvestor.com.au for more.