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As the famous British economist, John Maynard Keynes put it:
Irrationality should be expected by an investor in a sizeable part of his/her investing experience, and sometimes, this irrationality provides an investor with pockets of space that appears cheap amid a widespread sell-off.
And, it may not be an opportunity when investors are putting money to work when markets are trending higher along with the companies under their conviction.
A business could be good, very good, excellent, but whether the investment in the same business at the given asking prices reflects compelling attributes should be a meaningful question that investors should ask.
Since Coronavirus pandemic has taken centre stage, the wealth destroyed by the global markets is not quite drastic. It is pretty early to predict the consequences of coronavirus, and the longer it takes to remediate the status quo, the risks of adverse consequences increases.
A deteriorating economic activity, due to Coronavirus, in China means slower economic growth for the globe, and the Chinese officials would come back stronger augmented with policy support, as the second largest economy envisages a recovery in the economic front with phase one trade deal completed, China may have ambitious plans going forward.
Markets are more susceptible to fundamentals
A gradual shift in the fundamentals of a business is likely to drive the shareholder value and deteriorating fundamentals of a business could lead to the destruction of shareholder wealth in the short-term as well as long-term.
If multiple expansions were instigated without a similar favourable shift in the fundamentals of the business, the chances are higher that the market could correct the given prices and multiples.
Fundamentals of a business do not only mean earnings but a wider range of decisive factors that an investor should consider in preventing any sort of permanent loss of capital. So, let’s talk about some fundamentals other than earnings. However, earnings of business remain a major catalyst in delivering sustainable returns.
Cash flows
Cash flows in a business are among the major influences in the going concern principle of a business. The business generates cash flows through revenue/sales primarily, and other sources include financing and investing.
Free cash flow of a business means the amount of residual cash with the business entity after accounting for operating expenses and capital expenditure. It depicts the headroom for a business to pay off its short-term liabilities (debt) and its shareholders through dividends.
The level of free cash flows generated by a business depends on the stage of the business; when businesses are small and growing their propensity to burn cash and investment in capital expenditure is higher, it results in a compressed cash flow state.
Good Read: Market Pessimism Grows Stronger Over Coronavirus; Risky Assets Under Pressure, Gold Near Record Peak
Margin expansion
Perhaps one of the most significant metrics of the business that would deliver shareholder value over the holding period in an investment. It means the ability to drive earnings growth without a similar change in revenue/sales.
There could be many margins for a business, including gross profit margin, EBITDA margin, operating margin, EBIT margin, net profit margin, pre-tax profit margin etc. And, the company’s ability to improve these margins overtime depends on idiosyncratic factors.
Margins are adversely influenced by growing competition, cost of inputs, regulatory developments, and developments in macroeconomic factors etc. Thus, there are risks systematic risks as well as unsystematic risks to the margins of a company.
And, sound management, leading and time-tested strategies, performance evaluation and enhancement, execution skills etc. would play a defining role in managing unsystematic risks to margins, and for margin expansion trajectory of a business.
Market potential
It is essential for the companies to emphasise on their customers or potential customers, and businesses would need to place similar focus on customers of its products along with the product.
Assessing the market potential of the products by a business is crucial to forecast a target market share for the products. It includes a range of considerations for a business to trace market opportunity/potential of a new product.
A lot of questions are asked by the companies, including intensity of competition, adjacent opportunities, business environment, target market, market trends, evolving customer preferences, product differentiation, barriers to entry etc. After a thorough analysis, the businesses project the size of their target.
More importantly, investors should test the targets of the business, capabilities of the company to achieve that target, and efficiency of resource that are applied to achieve targets.
Capital Allocation decisions
Capital allocation decision in business could make or break the potential future of the company, and the management of the company is responsible for making these decisions.
Broadly, the capital allocation decisions of business include merger and acquisition, organic growth, share buy-backs, debt repayment and dividends.
As companies pass through their lifecycles, there are times when attractive opportunities (consider a merger) are presented with the management to position the business to deliver sustainable returns over time.
Management of the companies may decide to capitalise on the given opportunity after reviews and to assess the expected potential, and sometimes the decision making by the management could deliver adverse implications as well.
Capital allocation decisions also include decisions like launching a new product, expanding capabilities, and consequently renewing the growth potential of the overall business.
Investors should emphasise on the capital allocation decisions of the business, as the implications of these decisions would shape the future of the company, and the potential shareholder returns.
Should you buy amid a market sell off?
One thing which comes along with a stock market sell off is the renewed level pessimism that drags the prices of the potential investment to lower levels. Thus, an investor is provided with a renewed margin of safety, which was not available prior to the market sell-off.
However, the investors should consider the core fundamentals of the business as well as industry, economy, business environment etc. And, the strength of the business that could sustain an extremely adverse environment such as an economic downturn to avoid any permanent loss of capital.
