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Asset Management with Woodhill

Woodhill simplifies investing. We invest when we believe the risk is low and seek to protect your capital when we see risk as high. Our approach focuses on generating returns in all market conditions, with transparent and competitive fees.

We’re based in Bath, England, and are approved by the Financial Conduct Authority.

REAL-TIME WATCH

Up-to-date information on Woodhill Equity Fund and investment news.

Woodhill’s Paul Wood returns to Professional Adviser with a look at stock market crashes, the rational and the emotions

Stock market crashes are the black holes of finance. No one fully understands them, yet their extreme nature suggests that they may tell us something important about how markets really work. While black holes are studied extensively, the same is less true of market crashes. There may be a reason for this. In a world of efficient markets and rational actors, there is little room for violent and apparently inexplicable events such as the crashes of 1929 or 1987.

True crashes are also rare, making it difficult to draw firm conclusions from them….

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When the Bull Stops Running

Bear markets and crashes are very different things. Bear markets can sometimes be identifiable and often have a recognisable pattern. It may be possible to see the conditions that precede them developing, just not exactly when they will occur.

Market crashes are a very different thing. They remain mysterious and are to market historians much like black holes are to theoretical physicists. They are extremely difficult to predict. For instance, the most famous crash (1929) occurred when the US stock market was very expensive (Shiller CAPE at around 31x), while the 1987 crash occurred when the market was ‘cheap’ by today’s standards. The Shiller CAPE at the time was around 18x compared with around 40x today. Valuation on its own has historically been of little use in predicting a crash. Fortunately, crashes are relatively rare. What is most interesting about them is that while they are a mass participation event (i.e. many sellers), even the people living through them often struggle to explain exactly what happened. This is itself fascinating and suggests that there may be (like with black holes) some important hidden truth here – but this is something for a different article.

Bear markets, by comparison, can be more understandable. Valuation can matter, and bear markets have historically displayed patterns and a type of anatomy that can be studied.

So, what causes a bear market? There is so much that could be written about this – but for an article of around this length there are some important historical observations that stand out.

  • Bear markets have often occurred sometime after a valuation spike or peak. This occurred ahead of the Great Depression, the 1970s bear market and the bear market of the early 2000s.
  • Bear markets have often followed either a wave of technological innovation (radio in the 1920s, photography and TV in the 1960s, the internet in the 1990s) or a fixed-asset investment boom (housing in the period leading up to 2007). A common characteristic has been overinvestment in a key and economically significant sector.
  • They are typically a much longer process than a crash. Unlike a crash, which can take place very quickly, bear markets can take years and are rarely a straight-line event. Historically, major bear markets have often taken several years to complete. One reason is that overinvestment in the booming sector needs to be worked through or reversed. This can contribute to a decline in earnings growth and may involve insolvencies and, in some cases, banking-sector problems, as occurred around 1929 and 2008.
  • Bear markets have often ended after much of the valuation increase associated with the preceding boom has reversed. A good example is the period from the 1990s into the early 2000s. The internet-related boom started in the mid-1990s, when the internet really started to take off. The Shiller PE was around 21–22x. The multiple peaked at around 43x in 2000 and subsequently returned towards the 21–22x level.

So where are we now?

A number of the characteristics historically associated with bear markets are present today. There has been a significant valuation increase (the Shiller PE is currently around 40x), and there has also been a very large investment boom associated with AI.

What might happen next – and how long could it take?

If some of the major AI projects ultimately turn out to represent significant malinvestment, this could contribute to a future bear market. ChatGPT was launched in November 2022. At that time the Shiller PE was around 28x. A return from the current level of around 40x to 28x would, all else being equal, imply a market decline of around 30%. In practice, of course, earnings and valuations change over time, so this should be regarded as an illustration rather than a forecast.

Another way of looking at this is that around the time ChatGPT was launched, the US market was substantially below today’s level. A return to those levels would therefore represent a significant decline. Again, this is an illustration of valuation risk rather than a prediction of where the market will trade.

Historically, major bear markets have sometimes taken three years or more to play out. An investor who believed that a bear market was beginning could simply decide to remain out of equities for an extended period. The obvious difficulty is that this could mean missing substantial gains if that judgement proved wrong, or during the significant rallies that can occur within bear markets.

Bear markets are multi-year processes and can involve substantial swings in both directions before the whole process is complete. This creates both risks and opportunities for active investment managers. An investment approach that pays particular attention to valuation, market history and downside risk may seek to navigate these periods by reducing exposure to significant market falls while retaining the ability to participate when conditions improve.

This type of environment is particularly relevant to the investment philosophy we have developed at Woodhill. We will see what happens next, of course. The future is inherently uncertain, but current valuations and the scale of investment associated with AI make this an unusually interesting period for investors.

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The case for Johnson Matthey after the Honeywell deal

Our objective is to help investors compound wealth by owning outstanding businesses, while seeking to reduce the emotional and financial cost of major market falls. That inevitably influences where we look for new investments. We are less interested in chasing fashionable companies on increasingly demanding valuations and more interested in finding good businesses where change creates an attractive balance between risk and potential reward.

Johnson Matthey is an interesting example.

The company has agreed to sell its Catalyst Technologies business to Honeywell for £1.325bn. Following the disposal, around £1bn is being returned to shareholders through an £800m special dividend and a £200m share buyback.

What remains is a more focused collection of specialist businesses built around Johnson Matthey’s considerable expertise in platinum group metals. These serve a range of industrial and environmental applications where technical knowledge, intellectual property and long-standing customer relationships create meaningful barriers to entry.

Analysts currently expect relatively little sales growth over the next few years, but earnings per share should grow considerably faster, helped by the reduction in shares outstanding. On current forecasts, the valuation could quickly fall towards little more than 10x earnings.

For a specialist business of this quality, we don’t think it is unreasonable to envisage a valuation of 15–18x earnings if management delivers. There is also the possibility that a simpler Johnson Matthey ultimately attracts a buyer.

Importantly, we don’t need everything to go right. The combination of a substantial return of capital, a more focused business, earnings growth and a relatively modest valuation is precisely what makes the opportunity interesting to us

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Fund Updates

The Fund

VT Woodhill UK Equity Strategic Fund in GBP (Source: VTIM)

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We launched the VT Woodhill UK Equity Strategic Fund on 2nd June 2014 as a UK large-cap equity OEIC. This means we’re domiciled in the UK, not abroad, and invest in large public companies. We’re authorised by the FCA in accordance with the UCITS Directive.

The fund’s objective is to generate a positive capital return over a 12-month period irrespective of market conditions.

Financial Thoughts

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This website is provided by Woodhill Asset Management LLP, which is an authorized fund manager regulated by the Financial Conduct Authority in the United Kingdom. The content of this website is for informational purposes only and should not be considered as investment advice or a recommendation to invest in any of our funds. Please contact us for more detailed information concerning the investment management services we provide to clients.

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Woodhill Asset Management LLP is authorised and regulated by the Financial Conduct Authority in the United Kingdom, registration number 649832. This status can be checked with the FCA on 0800 111 6768, or on the FCA website. Registered in England No. OC389733.

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