Protect your cash by investing in strong companies

While the rebound elsewhere has not been as spectacular as in the US, European and Japanese equities are still up 130-150 per cent on a total return basis over the past five years. The surge in developed market equity prices has been accompanied by a dramatic change in sentiment.

While in March 2009 most investors were extremely pessimistic and fearful of a systemic collapse, many investors today see equities as poised to march higher, boosted by easy monetary policies and technological innovation.

For value investors, who strive to buy securities trading at a discount to their underlying intrinsic values, today’s environment is challenging. There are simply fewer high quality businesses available at attractive valuations. Given this environment, what should value investors do? Here are five strategies equity investors can employ.

• Sell when share prices reach their intrinsic value estimates: While many investors prefer owning a good business to holding cash, when share prices reach or exceed their intrinsic value estimates, it is generally time to exit the investments. While holding higher levels of cash in a rising market may not feel good, cash provides great protection and flexibility in a down market.

• Avoid the temptation to buy lower quality businesses: In past cycles, when equity valuations have become more expensive investors have sold higher quality companies trading at elevated valuation multiples and reinvested in lower quality companies trading at still reasonable multiples. This ‘trading down’ is a mistake. When the next downturn does occur, the lower quality businesses are generally the ones that see their earnings and cashflows decline the most.

• Insist on balance-sheet strength and high levels of free cashflow: Companies with conservative balance sheets that generate high levels of free cashflow are much better positioned to handle economic shocks.

• Keep hold of businesses that are well positioned for the next decade: When equity valuations appear high, there is a temptation to sell to raise cash to try to time the market. Unfortunately, this is extremely difficult. The best way to create wealth is by owning high quality businesses over many years.

• Partner with management teams that are proven operators and capital allocators: A capable management team that executes well, thinks strategically and allocates capital effectively should add tremendous value to a business.

Equity valuations today are not as attractive as they were five years ago, or even a year ago. Today is a time to be careful and patient. The benefits of value investing – the ability to protect and grow capital in both weak and strong markets – should prove particularly evident in the years ahead.

Tim Hartch is co-manager of the BBH Global Core Select fund

VALUE INVESTING: WHAT IS IT?

• Value investing is effectively selecting stocks the investor believes the market has undervalued for whatever reason, and that are trading at less than their intrinsic value.

• The key question in this scenario is what the intrinsic value of those stocks might be, as different investors can come up with different values. This allows for another key feature of value investing, known as the ‘margin of safety’, where investors buy the stocks cheaply enough to allow for any discrepancy in their version of the intrinsic value of the stock.

• Well-known value investors include Berkshire Hathaway’s Warren Buffett and former Legg Mason chief investment officer Bill Miller.