The stock market looks volatile right now. But a big decline in share prices could be a huge opportunity for long-term investors.
Quality shares often trade at high multiples, which makes them risky. A stock market crash, though, could change all of that.
Getting what you pay for
A lot of the time in life, you get what you pay for. But that’s because a lot of what you buy isn’t through the stock market.
Share prices move around more often and more dramatically than the price of cars, clothes, or coffees. And that means a couple of things.
When prices get too high, investors can find themselves buying stocks for more than they’re worth. That’s a good situation for sellers.
Equally, stock prices can fall below the intrinsic value of a company’s shares. In that case, buyers can get outstanding value.
As an example, shares in BP are up 35% so far this year. Yet I doubt that the business is 13% better now than it was at the start of January.
Higher oil prices definitely help. But my strong suspicion is that the stock was either cheap in January, expensive now, or both.
Quality shares
Most of the time, the stock market is pretty good at recognising quality companies. And this is usually reflected in higher valuations.
That makes buying risky. High multiples mean returns depend on future growth and there’s always a chance this doesn’t materialise.
A good example is Halma (LSE:HLMA). It’s a high-quality business, but it’s generally come with a matching price tag in recent years.
The shares have largely traded at a free cash flow multiple above 30, implying a starting return below 3%. So returns have depended on growth.
Halma hasn’t had much problem with this – it’s been an excellent acquirer of industrial safety businesses. But there’s always a risk with this strategy.
Valuations
The danger is the chance of overpaying. And Halma has shown a willingness to pay higher multiples for what it sees as better businesses.
That’s worked well so far and this isn’t just an accident. The firm has experience identifying, buying, and integrating acquisition targets.
I think there’s a good chance it can continue. But the current valuation means the odds aren’t as far in my favour as I’d like right now.
A free cash flow multiple of 33 implies a 3.3% starting return. That’s well below the 4.7% yield on offer from 10-year government bonds.
A stock market crash could change that, however. In fact, if the bond prices rise while stocks fall, the equation might even reverse.
Being prepared
Falling share prices are bad news for anyone looking to sell. But for long-term investors they can be an absolute gift.
Investors rarely get a chance to buy stocks like Halma at attractive multiples. But this is what a stock market crash can provide.
Nobody knows which way share prices are going in the next week or month. Despite this, I’m keeping a close eye on Halma right now.
I’m not deliberately waiting for a crash. But I’m making sure I know what I want to buy when one comes, rather than waiting until it does to figure it out.
