All four major index funds have suffered significant losses since 2022. The Russell 2000 Index has dropped 33.2% from its all-time high, and the Dow Jones, which consisted of mainly blue-chip stocks, has decreased by nearly 20% from its all-time high. The stock market has officially turned bearish, which makes it critical for investors to manage their portfolio properly in order to survive the bear market. Therefore, it is important that investors can complete the following tasks
Identify the high-quality businesses in their portfolio
Determine the intrinsic value of their holdings
Ensure they have sufficient margin of safety in their holdings
Plan with their financial advisors
In this article, we will discuss how investors can identify the high-quality businesses in their portfolio. Investors should start looking over each company in their portfolio and determine which companies are high quality and profitable. Now, many may wonder what defines a high-quality company. A high-quality company should exhibit the following characteristics: high returns on capital and modest leverage.
Under the current environment, the FED is raising interest rates and the demand is receding. Low-quality businesses without attractive products or good business strategies will be likely to experience substantial loss as purchasing activities will likely decrease in the upcoming years. Low-quality companies usually have tremendous debt, lose money from its core business activities, and suffer from poor management.
The return of capital of a company serves as a measure of the profitability and value-creating potential of companies relative to the amount of capital invested. For example, if you start a hot dog stand in Manhattan, and you earn $3 from each hot dog that you sell for $10, your profit margin will be 30%. Let’s say the initial investment is $10,000, and if you sell 10,000 hot dogs during the year, your return on capital will be 300%.
Companies with high return on capital indicate a sustainable business model producing massive profits and that these companies have superior competitive positioning in their industry. Take Apple, for example. Apple’s return on capital is 54% in 2021, meaning that the company earns $1.54 for every dollar that it has put into the company. This is the end result of Apple being one of the most successful companies across the globe.
When it comes to debt and leverage, many investors may think debt will hurt a company more than it helps. Although the idea of which may not be one hundred percent correct, high leverage will magnify a company’s risk significantly if there is a downturn.
Low-quality companies often do need to borrow a lot of money to support development and innovation; however, too much debt can greatly diminish a company's return on equity and profitability if there is a downturn. A great business doesn’t need leverage to earn a high return of capital. In times of economic crisis, businesses with lots of leverage and weak balance sheets are the first ones to go out of business. Vast majority of business failures or investment failures are a direct result of excessive leverage.
Credit: Google Image
During recessions, depending on leverage, the same hot dog stand can be in two different situations.
The business will continuously generate profits and survive when demand recess due to its high-profit margin.
Will be just as profitable or more when demand comes back up again.
The business’ capability to produce substantial profits will be severely limited as most of which are going into loan and interest payments.
Unlikely to stay solvent during an economic crisis.
Credit: Google Image
Furthermore, temporary demand fluctuations do not affect long-term demand, which means companies with profitable products and modest leverage will continue to thrive in the long run. In the long run, high-quality businesses are like tennis balls; when they get hit by a crisis, they will always find a way to bounce back. Low-quality businesses, on the other hand, are like eggs. Whenever a crisis strikes them down to the ground, they crumble permanently.
By identifying high-quality businesses, investors can be assured that their portfolio will be able to handle economic downturns with ease, and come out the other side stronger. In the next newsletter, we will discuss how investors can calculate intrinsic value and can make more educated selling and buying decisions.
By: Siddharth Singhai and Yang Peng
Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. The views and strategies described may not be suitable for all investors. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.