Turmoil may herald long-term bear market, says Stick

The whips and saws of the past few months have brought home to us the benefits of a disciplined and cautious investment process.

Pricing inadequacy is often cited by insurers when they refuse to write or renew insurance premiums: basically, the prospective returns on offer don’t justify the risks entailed.

In the first half of the year, many stock market prices failed to compensate us for standing under the storm clouds we identified; principally, the sovereign debt issues in the US, the UK and Europe.

We were already in defensive mode in January, with no shares in banks, miners or life insurers, and we reduced our exposure to some small and mid caps where their market valuations no longer made sense. Instead we took refuge in blue chip compounders (such as GlaxoSmithKline, British American Tobacco, Unilever and Diageo), which promised limited risk for big, rising dividends.

The point is that these actions were not based on prediction. They merely reflected the recognition that risk rises and returns fall in the presence of high prices.

Following rapid stock market declines since the end of July, the aforementioned concerns are finally becoming mainstream. Economic data and ultra low bond yields suggest the turmoil may only be the start of a longer bear market.

If so, the values we see today will look pricey alongside the values yet to come. Not knowing the future, we proceed with caution. We are, however, encouraged by the recent sell-off because spend-thrifts like us welcome a sale.

When sentiment rather than hard-headed analysis sets daily prices, bargains will emerge. Our assessment of the risks hasn’t changed from earlier in the year but the pricing environment has improved. These are ideal conditions for those focused on underlying value rather than price momentum.

Our compounders have retained their values, as other investors come to favour their earnings quality. Much as we like these companies, we recognise that the opportunity cost of owning them grows as the rest of the market falls in price, so we are beginning to find other companies with attractive risk/reward profiles in more cyclical areas of the market. We added to existing holdings – some good investments just got a whole lot better. We made new investments in good stocks that became "babies in the bathwater" and fell through our price targets.

Hindsight will reveal mistakes especially quickly in volatile markets. We will make our fair share because nobody can tell what the future holds. However, the benefit of a conservative investment process, diligently followed, is that it limits the magnitude of errors while retaining the benefits of any successes – seeking the best companies at the best prices to manage risk for higher returns. This is a reliable compass to carry the fund through choppy waters.

Carl Stick is manager of the Rathbone Income fund. The views expressed here are his own.