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What’s actually is a poor “performing” market?  Markets where prices are declining are generally referred to as “poor performing”.  Is this really true?

If the function of a market is to unite buyers and sellers and a reasonable volume is being traded would you say that the market is performing badly because prices are going down?  Clearly the buyers are getting what they want (or they wouldn’t buy) and the sellers are getting what they want (or they wouldn’t sell!).  Therefore it’s not the market that’s “performing poorly”.

Often it’s not the companies themselves that are performing poorly either, it’s more an expectation that they might.  To illustrate, let’s look at Commonwealth Bank over the last couple of years.

The table below shows CBA’s Net Profit After Tax (NPAT) over the last few years (on a cash basis)

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The table shows that after years of strong earnings growth (and hence dividends), earnings growth slowed and then reduced in 200 before leaping again in 2010.  To get a true picture of the financial health of this company however, Investors look beyond the headline numbers to see what impacts there may have been (good or bad) and whether these are likely to be repeated.

Investors would not have had to look too deeply into CBA’s results however to see the company had decided to substantially increase its overall financial strength (essentially its balance sheet).  In other words the company was not “doing worse”, it was in fact taking the opportunity to strengthen itself because it believed trading conditions would be significantly more difficult in the near future.  They obviously felt the previous few years had been fairly easy and now the cycle was likely to turn and they wanted to be prepared for it.

This is exactly what you would expect from quality management in a well run business.

CBA is essentially a money trader, they borrow money from investors, both retail (bank accounts, term deposits etc) and wholesale (money market).  They then lend this money out and the margin they make is effectively the bank’s earnings.  In this respect a bank is just like any other business.

Any business faced with rising input costs (the price of money[1]) and possible increase in bad debts (borrowers unable to meet payments or falling behind) would be silly if they didn’t prepare for these conditions.  CBA saw this coming and increased their bad debt provisions and strengthened their balance sheets significantly in response to this threat.  This created two extremely positive upsides for CBA as the cycle turned.  Firstly, much of its competition, both for investors deposits (CBA’s wholesale product) and borrowers either reduced significantly or disappeared.  Apart from government guarantees (which were almost universal around the world) CBA’s balance sheet strength still put it in a much stronger position during the crisis.

Imagine if in your business as you came to the end of a business cycle, you were given the opportunity to go through such a savage end that would flatten your profits for 3 years, wipe out a number of your competitors and devastate the vast majority of the rest of them.  Would you welcome a couple of tough years to get that kind of leg up on your competition? What if after all that you could also emerge twice as strong as you went in?  Now would you take it?

This opportunity sounds virtually impossible, the stuff of corporate legend that has only ever happened to a few lucky companies.  This however is pretty much exactly what’s happened to CBA.  Importantly, it didn’t take much effort for the average investor to see this at every stage over the last few years.

Now I’m not suggesting that CBA is alone in the experience, most Australian banks can claim similar positions, I’ve chosen CBA purely as an example of an company whose possible experience was relatively easy for Investors to predict throughout the last few years and as such provided no justification for a significant revaluation of its Real (intrinsic) value.

If anything, an Investor would have taken the view that CBA, at least on a relative basis, will be a far better company at the start of the next cycle than it has ever been before.

So if that’s true, and Investors drive the market, we shouldn’t see any material difference in share price over the last 3 years should we?  Let’s have a look.

Since July 2007, CBA’s share price has been as high as $60 in late 2007, below $27 in early 2009, back to over $57 by early 2010 and currently sits in the just over $50.  That’s a fair range by anyone’s measure.  But surely the GFC justified this? Investors ran for the exits as no one really knew what would happen! Well, not really.  Investors did exactly as I outlined above they looked at the factors above and in general decided that CBA in the medium term at least would be more than capable of justifying at least a $50+ share price.  Therefore at process below this they didn’t sell.

The world’s most successful investor Warren Buffett famously bought into US financial companies during the worst periods of the GFC purely on the basis that “they are smart guys and they will find a way to make money again”.

In September 2008 just as Lehman Brothers collapsed at the GFC entered its darkest days Buffett was buying into Goldman Sachs and continued buying financials even through 2009. When asked about the Goldman investment Buffett was quoted;

“I think the Treasury will pay back the $700 billion and make a considerable amount of money,” Buffett said, adding that if he had $700 billion on the government’s terms to buy distressed assets, he would. “Unfortunately, I’m tapped out.”[2]

So during this period, the market performed well (buyers and sellers united, Billions of shares successfully changed hands) and CBA as a company performed well, grew profits whilst significantly increasing financial strength and competitive advantage.

The only ones that ended up “performing badly” were those who owned shares like CBA and cashed up to avoid “losing money”.  Fortunately, Investors didn’t.

But what about those smart investors who sold out high, bought and back in low?

Surely they made a killing? Aren’t they the real investors?  Whilst it’s possible someone actually did, just as someone actually wins lotto despite the individual odds, that doesn’t mean it’s predictable.  As outlined above, Investors make financial decisions based on sound principals which are likely to produce predictable results.  Nothing over this or any other period of increased market volatility indicates it’s possible to do so with any degree of accuracy.

The UK magician Derren Brown once demonstrated that whilst improbable it is possible to toss a coin and get 10 heads in a row.  Possible yes, but given it took him 9 hours of coin tossing to achieve this, were this a financial result, the number of “failed” attempts would surely have led to ruin well before success could be achieved.

 

Matt Battye

Matt Battye

CEO, Financial Adviser

Analysing what can seem to be like complex issues, Matt is effective in using analogies to better explain scenarios and truths to the rest of us. This is what Matt enjoys – educating clients on the truths and debunking the commonly held (wrong) view.

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