Prime Value’s views on current market volatility. The Importance of prudent stock selection

ST Wong, 28 August 2015

Given current market volatility, we thought it timely to provide a brief update as to our thinking with regards present market conditions. August has clearly been a challenging month for equity investors, with major sell-offs across global equity markets. With two trading sessions remaining, the Australian share market is down approximately 7% over the month, despite the strong recovery over the past few days.

The key driver of the downturn has been indications of a deteriorating Chinese economy and its implications for global growth and key commodity prices. A weaker than expected domestic reporting season and increasing pressure on the banks have also combined to drive down share prices across the board.

While share market downturns can be unnerving, Prime Value’s experience over the past 18 years is that periods of broad-based selling typically provide very attractive entry points for selective deployment of cash into both existing holdings and an active pipeline of alternative ideas.

Without dismissing the ramifications of a slowing Chinese economy, we’re not necessarily any more cautious than we were entering the new financial year, having maintained our underweight positions to both the banks and resources over this period, along with reasonable levels of cash heading into the reporting season. In our view, emerging markets such as China are adjusting their economic models. Such adjustment necessarily involve periods of uncertainty, partly due to misinformation and lags in information. We take comfort that emerging markets in general, and China specifically, have monetary tools at their disposal to create buffers for their economies. For example, if the People’s Bank of China (the Chinese central bank) were to reduce Chinese banks’ Reserve Requirement Ratios by 1%, Morgan Stanley estimates the impact as equal to a $200bn injection into the monetary system.

While we expect volatility will persist, the Australian market is now trading on more reasonable valuations, which is creating more opportunities for prudent stock selection under a longer-term investment horizon.

The performance of our underlying holdings and overall Fund performance has generally held up well during the August reporting season, providing a buffer against challenging market conditions. We attribute this performance to our philosophy of minimising mistakes; the strong fundamentals of our underlying investments; and diversification of ideas at portfolio construction. These attributes are non-negotiable in the management of high conviction portfolios and should hold the Funds in good position to navigate inevitable periods of market stress going forward. While periods of volatility like we are experiencing can be unsettling they can also provide an ideal time to selectively add stocks to the portfolios where appropriate and we will continue to search the market for companies we find attractive at current levels.