Peter Hodson: Big profits are going to be made when – not if – the market changes

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Most investors — it seems all investor – are negative these days. There’s definitely a lot to worry about, you know, just little things like massive inflation and the threat of nuclear war.

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Yes, we are in a bear market and it has been painful. But the smartest investors know that the conditions that exist today won’t last forever. Investors with a long-term perspective look ahead and try to set up their portfolios for the conditions that will exist in the future, not for the conditions that exist now. Big profits are going to be made when – not if – the market changes.

If we assume that the market will one day go up and growth will return, how do you configure your portfolio for this inevitability? Here are five strategies to consider.

Don’t carry too much cash

The urge to hold cash right now is probably very high. With many stocks down 60% this year, cash looks attractive, even after taking into account the loss of purchasing power due to inflation. But you need to have something other than cash to maximize potential returns in a market rally.

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Cash returns close to 5% (on some Guaranteed Investment Certificates), but some stocks will double or triple when the market goes into bullish mode. Savvy investors know how to buy when everyone else is selling, and that’s certainly the case today.

Owning high growth stocks – no, really

Many investors dipping their toes into a bear market will start with ultra-conservative stocks, such as those in the consumer staples and utilities sectors. It’s a strategy, but investors should look to growth stocks and smaller companies (see below), if they want really big returns. It’s absolutely true that a stock that’s down 80% may never return to its previous all-time high, but it can still double, triple, or more.

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Growth stocks are absolute pariahs right now, and stocks that were once 50 times the sale are now 3 times the sale. Many businesses continue to grow at over 50% even in a weakened economic environment. Remember that in a recession, investors will likely pay After for businesses that can still grow while everything else recedes.

Look for companies growing 50% today (a Bloomberg screen this week shows 982 North American companies with expected sales growth of 50% or more next year). Even in a recession, many of them will continue to grow at over 20%, which could be very attractive for investors when the economy contracts.

Don’t pay too much for security

Scared investors flock to so-called safe investments, such as food companies and utilities. Again, nothing wrong with that, and most companies in these sectors offer reliable and growing dividends. But investors need to be careful what they pay for security.

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The valuations of many companies in these sectors are reaching historic highs. Companies with historical average price-to-earnings ratios around 15x see their valuations exceed 20x. A change in valuation can still result in significant losses, even with safe stocks.

We do not recommend charging to safe sectors. Keep diversification in mind. Everyone needs to eat, but due to low margins, inflation and higher interest rates can also have a serious negative impact on food businesses. Nobody wants to see their safe stock go down 25% because they paid too much for it.

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Buy long-term bonds

Bonds have been crushed this year and long-term bonds have been decimated by soaring rates and inflation. But if we look ahead, remember that higher rates have a slowing effect on the economy. In a typical business cycle, rates rise, the economy slows, and then eventually rates peak and begin to fall.

In a recession, and assuming interest rates peak, long bonds could be one of the best performing asset classes. It’s impossible to time, of course, but today’s investors simply ignore bonds, and we think that’s a mistake.

Small caps tend to drive markets higher

We’re biased here because we’ve always focused on small- and mid-cap stocks, but smaller companies tend to lead the market higher in a rally. And they are historically cheap. Right now, they’re about as cheap as they’ve ever been compared to large caps, as scared investors pay more for the perceived safety of larger companies.

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Small caps tend to have purely domestic income, so you don’t have to worry about war or recessions in China and Europe. Small caps tend to have healthy balance sheets because banks don’t want to lend them a lot of money. Small caps tend to have more insider participation, so executives are highly motivated and aligned with shareholders.

And, of course, small caps are easier to acquire for larger companies. During a recession, many large companies will attempt to supplement their growth with acquisitions of smaller, faster-growing companies. If current valuations persist, this is likely inevitable.

Peter Hodson, CFA, is Founder and Head of Research at 5i Research Inc., an independent investment research network that helps self-directed investors achieve their investment goals. He is also a portfolio manager for the i2i Long/Short US Equity Fund. (5i research does not own Canadian stocks. i2i Long/Short Fund may hold non-Canadian stocks mentioned.)

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