Part of the nature of the stock markets is that prices fluctuate from one day to the next. Sometimes, prices go up too much and subsequently crash. This cyclical movement is as sure as the tides, except that timing the ups and downs is almost impossible.
Long-term investors know that being out of the market tends to cost you. That’s why they are always invested in stocks, at least with some proportion of their wealth – even when the market is down.
This is also true for the Sifter Fund. We are invested in equities at a weight of nearly 100% in all market conditions.
However, this doesn’t mean that we simply sit on our investments and wait. So how do we prepare for tumultuous times in the market and take advantage of market pullbacks? Let’s take a look at this from the Sifter Fund’s perspective.
Prepare for pullbacks
First of all, we need to make sure that the companies we have invested in are of very high quality and have a strong business model. Historically, quality companies also hold their value better in market downturns. Of course, no stocks are completely immune to pullbacks.
The characteristics shared by high-quality companies include a strong market position, a predictable capacity to make money and a differentiated revenue model that involves clear competitive advantages. In addition to satisfying these qualitative criteria, a high-quality company has a healthy balance sheet and, ideally, is free of debt.
Want to read more about the quantitative and qualitative factors behind the superiority of high-quality companies? Download our Long-term quality investing guide.
Sifter companies are strong
The table below illustrates the key numerical superiority factors of the companies in the Sifter Fund and compares them to the 500 largest companies in the United States (S&P 500).
We also keep an eye on many other company-specific figures, but these key business indicators show us that the companies in our portfolio are high in quality.
|Sifter Companies||S&P 500 Companies|
|ROIC (%)||18 %||8 %|
|Operating margin (%)||25 %||15 %|
|Sales growth (%)||1 %||-1 %|
|Net debt / EBITDA||0.1x||2.0x|
For example, the return on invested capital (ROIC) of Sifter companies is more than twice as high as their peers. Their operating margin is also remarkably high (25%).
It is also worth noting that their key figures did not decline during the year of COVID-19. This speaks to the importance of our companies’ products and services to their customers and their management’s ability to lead the business through difficult times.
Revenue growth was only +1%, but considering that the period in question was from April 1, 2020 to March 31, 2021, this is a fairly encouraging result.
The companies’ indebtedness (Net debt/EBITDA) is another important indicator. Sifter’s companies are practically free of debt (the median for this indicator is 0.1x), while the median ratio for companies in the S&P 500 is 2.0x, which means that their net debt is twice their annual EBITDA.
Two examples of Sifter portfolio companies are Verisign and Novo Nordisk. Verisign administers the domain names of corporate websites, such as .com and .net. It has a nearly monopolistic position in its industry.
The cost of Verisign’s services to its customers is laughably small (USD 8), but the service is highly critical from the perspective of the customer’s business. From the shareholder’s perspective, it is very reassuring that Verisign has excellent profitability and steady growth in its capacity to make money.
More information on Verisign and Novo Nordisk is provided in our guide: Long-term quality investing.
Risk-adjusted earnings yield – how do we make trade-offs between stocks in a declining market?
Since we are 100% invested in equities, it is characteristic of Sifter to make trade-offs between the companies in the portfolio. For these trade-offs in allocation to be successful, all of the portfolio companies need to be ranked according to their risk-adjusted earnings yield, which measures their expected shareholder return over a period of five years at the current share price.
When a pullback happens in the market, we already know which companies we will reduce and which ones we will increase. The aim is to achieve continuous gradual improvements in our portfolio of 30 high-quality companies.
Next, we’ll shed more light on these trade-offs by providing actual examples from the Sifter Fund.
Safran’s earnings yield tripled at the start of the COVID-19 spring
First, let’s take a look at Safran, the world’s leading manufacturer of aircraft engines. More than a third of Safran’s revenue comes from engine maintenance. The number of installed engines is tremendously high. The company also has a strong balance sheet. During the COVID-19 crisis, the stock prices of companies in travel-related industries declined by more than 50 per cent, and Safran was no exception.
If one believed that air travel will return to normal over the next 2–3 years, for example, Safran’s five-year earnings yield more than tripled at the share price at the time. This meant that Safran’s future (five-year) cash flows could be bought at a significant discount. Even though, the company’s capacity to make money in the short term (1–2 years) was uncertain.
To finance the purchase of additional shares in Safran, we had to sell other portfolio companies with a lower five-year risk-adjusted earnings yield.
These kinds of trade-offs in allocation are only successful when you know each company’s strengths and you have confidence in their business.
Microsoft: Tends to decline less than others, but its risks are also lower
In our view, Microsoft’s business model is unusually strong and stable. During times of crisis, the share prices of high-quality companies often decline too much compared to the strength of their business and their capacity to make money. For example, the price of the Microsoft share fell by approximately 27% during the worst days of the COVID-19 pullback (USD 137 on March 15, 2020), but the decline was much less drastic than in Safran’s case, for instance.
As the stability of Microsoft’s business involves substantially fewer risks, Microsoft’s risk-adjusted earnings yield was also quite attractive. These kinds of trade-offs in allocation are sensible when the portfolio includes a company with a similar earnings yield but the higher risk associated with future profit performance.
Pullbacks are nerve-breaking moments for investors
Investing in stocks is psychologically stressful especially in the absence of predetermined courses of action during pullbacks. While the downturn market is not a pleasant experience for anyone, it is worth taking advantage of the opportunities it offers.
Trying to time the market is a mistake that many investors make. If you sell during a pullback, you’ll probably sell too late. When you decide to buy in again, you might do that too late as well.
In our experience, it is not worth spending time guessing stock market movements. Instead, you should focus on long-term ownership of high-quality companies. This not only brings peace of mind, it often brings good returns as well.
Sifter’s role in an investor’s portfolio is to be an asset you can continue to hold even during a low tide in the stock market.
Interested in long-term quality investing? Download our 20-page guide: Long-term quality investing. Our guide explains how time and high-quality companies work in an investor’s favor.
CEO, Sifter Capital Oy