Don’t try to time the bottom – start buying good companies now

If you open any newspaper (or news app) today, you’ll be confronted with a tidal wave of bad economic news. The UK economy is going to be battered by an economic storm over the coming months and it is not alone. In Europe, the US and other international markets, inflation is driving economic disruption and uncertainty is the name of the game.

Against this backdrop you might think I’d be recommending that the best course of action for investors is to act defensively or sit tight and try and ride out the storm.

I don’t think that’s the right course of action. I fully acknowledge that the economic climate is likely to get worse before it gets better, but I’m also well aware that trying to time the market is almost impossible.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Don’t wait for the worst to pass

History tells us that the best time to buy stocks is at the point of maximum pessimism. The problem is, anyone who tells you they can perfectly time the point of maximum pessimism is lying.

There is a tremendous volume of research supporting this argument. In March last year, Bank of America looked at the returns of the S&P 500 index going back to 1930.

It found that even if investors only slightly mistimed the market, missing the ten best trading days each decade, they would earn a total return of 28%. In comparison, investors who held steady through the ups and downs would have earned a return of 17,751% – that’s not a typo.

Looking at these figures you might wonder why anyone would try and time the market? As with most things, the answer to that question is pretty simple; it’s all about money. Bank of America also found that if an investor correctly avoided the ten worst trading days of each decade, they would have earned a total return of 3,793,781%.

Unfortunately, the chances of being able to accurately time the market and avoid the worst trading days are tiny.

Assuming the market was open for five days a week during the nine-decade period under review, just 3.8% of days accounted for the biggest declines. To put it another way, investors who tried to avoid the worst trading days during these 90 years had a 96.2% chance of being wrong each day. Those don’t look like good odds to me.

There’s no sense playing a game where the odds are stacked against you, which is why trying to time the market makes no sense for long-term investors (short-term traders might have a different view).

However, while the odds of being able to correctly time market movements are tiny, the odds of a good company remaining so for two, five or even ten years are much higher.

Over the long-term equity returns tend to match underlying fundamentals

Over the long run, there is a high correlation between a company’s return on investment capital (ROIC) and the total return of its equity securities. Therefore, corporations that have entrenched competitive advantages and high returns on invested capital tend to be good investments no matter what the economic environment.

For example, a company that can consistently earn a 15% to 20% return on invested capital is likely to produce high double-digit returns for investors over the long run. Even if investors purchase high-quality enterprises like this at high valuations, the evidence suggests that they will earn an attractive return in the long run.

LVMH (Paris: MC), the most luxury of luxury retailers is a great example. At the beginning of 2007, the stock was trading at a price/earnings (p/e) ratio of 20.8, which some investors might have considered to be a bit on the pricey side. Since then the shares have gone on to return 15.2% per annum excluding dividends.

Granted, some of this growth can be attributed to multiple expansion, but not much – the stock is currently selling at a forward p/e of 21.9, according to Morningstar. Over the past five years the company has earned an average return on equity of 19.8% and a return on invested capital of 12.7%.

I think this simple example illustrates that buying high-quality companies, even at premium prices, is rarely a bad decision.

These are the choices investors have today. Either we try to time the market (and most likely get it wrong) or we continue buying the market’s best companies. I know what I’m doing. After recent declines some really great companies are trading at valuations that seem to discount their future growth potential.

Yes, there may be further pain ahead in the short-term, but in ten years’ time, I’m willing to bet companies like LVMH will be bigger and strong than they are today. That’s why now’s the time to buy. These businesses already look cheap. There’s no sense waiting around to see if they might get cheaper.