Market pullbacks are a normal part of equity investing. The pullback we are currently experiencing is not the first time this has occurred and it won't be the last.

Pullbacks present you with an opportunity to enhance your wealth or you can suffer a permanent impairment to your capital.

This article provides suggestions on how market pullbacks can be used to your advantage.

 

I strongly suspect many investors have been gripped with fear as a result of the recent market pullback. I am willing to bet many fear the pullback because they are upside down when it comes to their finances.

In my recent Fix Your Finances article I touched upon why it is important to have your finances in order. I also listed some of the preliminary rudimentary steps to take if your finances are in need of ‘some fixing’.

I fully appreciate that some readers who need to fix their finances are not going to enjoy this article. My intent, however, is not to upset people but rather to encourage readers to have their finances in order so as to be able to take advantage of market pullbacks.

Quite frankly, market pullbacks should be embraced. Market pullbacks are a normal part of investing in equities. Position yourself where you can embrace market pullbacks...not fear them.

Our recent market pullback pales in comparison to previous pullbacks. Don’t believe me? A few of the ‘biggies’ are the Great Depression (many people reading this were not around to experience the severity of this event), October 1987, the bursting of the dot.com bubble (late 1999/early 2000), and the more recent Financial Crisis.

While the Financial Crisis is relatively recent in the grand scheme of things, I strongly suspect many of today’s investors did not begin investing in equities until this event had blown over. I have no empirical evidence but I would not be surprised if many of today’s investors did not start investing in equities until post 2012. These investors have never really experienced a pullback of significance and probably aren’t ready for what could happen if this pullback persists.

The following are my suggestions on what investors should do to embrace market pullbacks.

Avoid the Use of Leverage

I have experienced previous rapid increases in equity values which were followed by dramatic pullbacks. I witnessed friends and co-workers whose finances were not in great shape and who compounded their problem by investing through the use of leverage (borrowed money).

In one case, a former co-worker borrowed $42,000 to acquire shares in Commerce One during the dot.com bubble. Wonder what happened to its shares which were at one time trading around $420? They went to zero.

This guy was stuck with a liability and no offsetting asset. His problems were compounded when he eventually had to fess up to his spouse about his terrible investment decision.

In a great many cases there are probably some investors employing the use of leverage as part of their investment strategy. In fact, some of these investors are probably in a predicament where they really should be focused on ‘fixing their finances’.

When you’re employing the use of leverage and you can’t ride out the storm, you risk a permanent impairment to your capital.

Have a look at the extent to which investors have recently been employing the use of leverage. The historical data tracked by The Financial Industry Regulatory Authority (FINRA) records:

• the total of all debit balances in securities margin accounts; and
• the total of all free credit balances in all cash accounts and all securities margin accounts.

Maybe it is just me but…..it looks like there might be a few investors out there with a SERIOUS amount of margin debt!

Borrowing to invest is a dream come true when the value of your investments continue to rise. When they fall, however, your dreams become nightmares. I strongly suspect many investors are currently having nightmares.

Warren Buffett, arguably the world’s most successful equity investor, has repeatedly expressed his disdain for the use of leverage. In Berkshire Hathaway’s 2017 Annual Letter to Shareholders, he reiterated why you should never borrow to buy stocks.

Maintain Financial Flexibility

When your finances are in order and you have financial flexibility, you can take advantage of opportunities as they arise. Keep some 'powder dry' so you're not scrambling to come up with funds when the stock price of high quality companies reaches attractive valuations.

As I compose this article, I see that every single one of our investment holdings is down over the last couple of days; the drops are typically less than 3%. The companies in which we own shares are still highly profitable, are generating strong free cash flow, and are still paying dividends/distributions with little risk of a cut/freeze. In fact, one of our investment accounts just received a semi-annual dividend payment from Diageo (NYSE: DEO). The last time I went to our local liquor store their products were still selling well!

In addition to the recently received dividends from DEO, the high quality companies listed below are some of the companies which will be showering us with dividends before the end of October. I strongly suspect none of these businesses are being managed on the basis of how their respective stock price has performed in this recent market pullback!

• Total (NYSE: TOT) (another American Deposit Receipt)
• Philip Morris (NYSE: PM)
• The Bank of Nova Scotia (TSX: BNS)
• The Canadian Imperial Bank of Commerce (TSX: CM)
• The Toronto-Dominion Bank (TSX: TD)
• BCE Inc. (TSX: BCE)
• Cisco (NASDAQ: CSCO)
• Smart REIT (TSX: SRU.un)

Every company reflected above is one in which I have utmost confidence will be even more profitable in the future than it is today.

NOTE: Keep in mind that one of the nice aspects of market pullbacks is that the dividends/distributions can be automatically reinvested to acquire shares/units at lower prices.

Careful With Those Valuations

Just because a company is profitable and is generating strong free cash flow, however, does not mean that it is a ‘BUY’. I have written several articles in which I have expressed my opinion that valuations were somewhat lofty and waiting on the sidelines was my preferred choice. Were these stock prices to retrace to more attractive levels, I indicated I would gladly add the currently overvalued company(ies) to our holdings.

I will readily admit that not every single one of my calls is correct. In some cases I have watched overvalued stocks continue to trace higher (eg. Moody’s (NYSE: MCO), S&P Global (NYSE: SPGI), Brown-Forman (NYSE: BF-b), Cintas (NASDAQ: CTAS), Ecolab (NYSE: ECL), and Accenture (NYSE: ACN)). The recent pullback, however, has knocked these stock prices back to levels which are approaching ‘reasonable’.

Think Like A Business Owner

If your intent is to create long-term wealth and an ever increasing stream of dividend income, it is imperative you think like a business owner and that you look at your investments from a ‘long-term’ perspective.

If your method of investing is to closely monitor the intra-day fluctuations in stock prices, 50-day and 200-day moving averages and other technical metrics, I urge you to stop this practice. The gyrations in stock prices do not accurately reflect the value of the underlying business. Stock price gyrations are set by what investors are prepared to pay for a fractional ownership in a company. Quite often, the prices investors are prepared to pay are totally detached from the underlying fundamentals of a company.

Take for example BlackRock, Inc. (NYSE: BLK). While not everyone reading this may be familiar with the company, I suspect most readers are familiar with their ishares family of Exchange Traded Funds (ETFs).

Around mid-January, the stock was trading at ~$594. The stock is now trading at ~$418 as I compose this article. In my opinion, BLK was overvalued in mid-January 2018 yet investors were still acquiring shares in the company. I suspect investors willing to overpay at ~$594 were not thinking like business owners and their investment decision was on the basis of FOMO (Fear Of Missing Out).

There is No Need to Speculate

Far too many investors confuse speculating with investing. A speculator will invest with the hope of generating a profit but will take on an inordinate level of risk. Examples of speculative investments would be the purchase of crypto currencies or the acquisition of shares in cannabis companies with no track record of profitability.

Investments, however, are made after having analyzed the fundamentals of a profitable company. The level of risk is typically far lower than with speculative investments.

While many people have improved their financial lot in life by having speculated, it is highly probable that a far greater number of people have suffered losses by speculating.

There is no need to speculate. A disciplined approach to long-term investing can create long-term wealth…and put you through far less stress.

Final Thoughts

In several of my recent articles I have expressed concern about what appears to be an element of market euphoria. I have perhaps sounded like a broken record and it is entirely possible some readers have perceived my level of caution to be somewhat unfounded. My objective in sharing my caution has not been to come across like ‘chicken little’. My intent was to impress upon readers that markets do not always go up and more realistic valuations for high quality companies are not out of the realm of possibility.

With the current market pullback I think there is a huge segment of investors who fear market pullbacks and many will end up making irrational decisions when they realize their tolerance for risk is not as strong as they had imagined.

If the plan is to use equity investing as a method of generating long-term wealth, my recommendations are:

• Fix your finances (this is not optional and should be done BEFORE you start investing in equities);
• Avoid the use of leverage (debt) when investing in equities;
• Maintain financial flexibility;
• Acquire investments that are reasonably valued;
• Think like a business owner and view your investments from a long-term perspective;
• Avoid speculative investments.

Here is a link to a recent post in which I have listed the companies in which my wife and I have invested. I am not suggesting that all these companies are favorably valued as we have acquired shares in these companies over a period of several years. The list, however, at least reflects non-speculative companies which are profitable and which are generating positive free cash flow.

On a final note, the current market pullback is not the first in history and it won’t be the last. Learn to embrace market pullbacks as they are periods in which you can either make money or experience a permanent impairment to your capital. Don’t make investment mistakes. Let others make them!

I wish you much success on your journey to financial freedom.

Thanks for reading!

Note: I sincerely appreciate the time you took to read this article. Please send any feedback, corrections, or questions to[email protected].

I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company mentioned in this article.