Global Equity: When buying great businesses, time will always be your friend.
"The fact that everyone is so bearish just makes me more bullish!"
The attack on Ukraine is an incomprehensible human tragedy. Our hearts go out to all those impacted. Investment losses are secondary and pale in comparison.
That said, this challenging backdrop is also a stern test for any investor and some are struggling to determine what the right course of action might be, turning their attention away from virology and towards military strategy.
FAANG 2.0 seems to be the latest fad … apparently market participants should now tilt their portfolio to incorporate the new world, a world of heightened geopolitical risk and resource scarcity; and therefore exposure towards Fuels, Aerospace, Agriculture, Nuclear & Renewables and Gold & metals/materials.
However, chasing returns has never formed the basis of any winning strategy; oil sold off heavily on the mere suggestion that Zelenskyy had cooled on joining NATO.
We believe that the most crucial thing to do is to avoid knee jerk reactions. What feels comfortable can in fact cost investors’ money. Blackrock summed it up perfectly:
"Amidst difficult financial times, emotional instincts often drive investors to take actions that make no rational sense but make perfect emotional sense".
Inadvertently, such investors end up buying high and selling low. Investors are far more likely to achieve better outcomes when they resist the urge to try and time the market. According to a study by Morningstar, investors who were invested in the stock market between 1997 and 2017, for all 5,217 trading days, generated a compound annual return of 7.2%. If, as a consequence of trading in and out of the market, the best 10 days of the market were missed, returns would have plummeted to 3.5%. If the best 50 days were missed, investors would have been left nursing a 4.5% loss. The challenge, which many market timers do not appreciate, is that the most significant gains in the market tend to occur during or just after a market drawdown.
Unfortunately for market participants, time and time again, over any reasonable time frame, the average investor underperforms. Many different studies over different time frames all lead to the same dire outcome. For example, according to a study by Richard Bernstein Advisors LLC, over a 20-year period the average investor made less than the three-month treasury bills. By trying to be too clever, investors keep losing money.
Another example which caught my attention was that of legendary investor Peter Lynch who returned in excess of 29% per annum over his thirteen-year tenure of the Fidelity Magellan Fund. Investors flocked as the fund ballooned from $18 million in 1977 to over $14 billion in 1990. Investors seemingly had done the hard part and correctly identified his talent. All they needed to do was simply hold on in order to achieve the 29% annualised rate of return.
Lynch had truly exceptional years of outperformance as well as years of underperformance. For instance, during those 13 years the market went down 10% or more 9 times. Every time it did, the fund underperformed. Apparently, time and time again, investors bought into the past performance and jumped on board as the fund shone and went on to sell, thereby crystallising losses, when it underperformed. Staggeringly, despite the incredible track record, It is claimed that the average investor lost money in the fund according to those familiar.
Institutional investors are not immune either. According to an article written by Gary Jackson, the Head of Editorial at FE Fundinfo Fund managers are now most bearish on growth since the financial crisis.
According to a Bank of America Fund Manager Survey taken in March 22, Fund Managers have responded to the crisis in Ukraine by increasing their exposure towards commodities and cash whilst lowering exposure towards equities in general, particularly Eurozone, Technology and Emerging Markets.
This suggests to me that even institutional investors are chasing returns; buying high and selling low.
Benjamin Graham's timeless piece of advice still rings true decades later:
“The investor’s chief problem – even his worst enemy - is likely to be himself”.
As Peter Lynch explains:
“In the stock market, the most important organ is the stomach. It's not the brain. It’s a question of what's your tolerance for pain. There will still be declines. It might be tomorrow. It might be a year from now. Who knows when it's going to happen? The question is: Are you ready - do you have the stomach for this?. Most people do really well because they just hang in there.”
Yet ‘hanging in there’ is what most investors seldom do. According to a separate study by Fidelity, inactive accounts outperformed active ones. It is often claimed that the investment accounts with superior returns are those who forgot about their investment or indeed are deceased. Of course, inactive investors do not worry about pandemics, wars, interest rates, inflationary pressures, possible recessions and neither do they have bright ideas such as chasing returns in oil or gold.
A colleague of mine has personal experience of this. His father died in January 2013; at that time his Japanese portfolio held just two shares – Keyence and Fanuc. This portfolio has not been touched since his death. While Fanuc has not covered itself in glory with only a 6.7% annual return, Keyence has returned 26.9% annually. They were equally weighted at the time of his death thus the portfolio CAGR has been 16.8% (26.9%+6.7% divided by 2), a 6.5% annual outperformance relative to the Japanese index over the last nine years!
Other studies also report a negative correlation between investor activity and investor returns. Simply put, investors keep shooting themselves in the foot.
The fears of slowing economic growth, inflationary pressures, tightening monetary policies and margin pressures which have all been exacerbated by the invasion of Ukraine are all understandable. Yet unfortunately for investors, by trying to predict the unpredictable, they end up merely speculating.
Adding to the confusion, many “value” investors, feeling vindicated by this year’s outperformance, believe that value is back in style and this is the beginning of a long term trajectory.
Yet investors who pigeonhole companies as growth or value stocks are simply setting themselves up for failure. I deplore this populist school of thought. Neither value nor growth companies are homogeneous. A lowly rated company is not going to become a great investment over time simply because it is lowly rated regardless of the latest flavour of the month, or what the latest “expert” states on CNBC.
Now I say this as somebody who has extensive experience of managing value, deep value and special situation strategies during my investment career. I fully understand that value investing, whilst having its pitfalls, does have its merits. All our equity funds employ a valuation overlay when selecting securities.
What many seem to miss with lowly rated companies is the high dispersion of returns; some will do very well and some will do very badly.
Is the company cheap because the market is wrong? Or is the market pricing in trouble?
It is absolutely critical, and a challenge for any value investor, to avoid value traps. Many large and medium sized companies are well covered by analysts. Furthermore, investors today have unprecedented access to information. More often than not, the market is right in assigning a lower valuation to a business. It is indeed the exception, rather than the rule, that the market is wrong.
I have the utmost respect for proper value investors who, through detailed research, are able to find the needle in the haystack and present well thought, analytical reasoning which is not oblivious to the fact that franchise value, capital stewardship, structural challenges and intangible assets should all be incorporated within the valuation model. At the same time, I am flabbergasted at how many investors simply buy on the basis that a stock is cheap on a Price to Earnings or Price to Book ratio. It is simply lazy and reckless in my opinion.
A financial advisor recently told me that, given the heightened geographical risk, oil is once again the new gold, and it will be good to have exposure to oil companies. He singled out Royal Dutch Shell as an attractive investment, believing that there is still much upside in the firm despite its recent outperformance, as it had not done so well during the past decades meaning that there is plenty of catching up to do.
Yet a quick study of the firm in my stock screener showed me that, over the past decade, the company generated Cash Flow returns on capital (CFROC) of just 4.8%. Therefore, the company has not been able to generate returns to compensate for its cost of capital!
Out of curiosity, I looked at a few other popular names from the FTSE100. BP was worst, its CFROC over the past ten years was 3.1%. Similarly, according to the same data vendor, Barclays generated a real return on equity of 3.1%. Lloyds Banking performed similarly and generated real return on equity of 3.2%. Yet many still wonder why the FTSE100 has done poorly over time.
This is akin to buying a cheap apartment to rent out as an investment where the rental income doesn’t even cover the cost of finance. While it might seem sensible to buy on the hope that someone else will pay more over time, that may or may not happen. Until it does, however, such investors will burn through cash. This is not something I find particularly desirable.
This is not ground-breaking or anything new. We are certainly not reinventing the wheel due to the low interest rate environment we have had during these past years. Way back in 1890, the brilliant British economist Alfred Marshall articulated that companies generate value when they grow and earn a return on capital that exceeds their cost of capital. Most of the so-called value stocks do not manage to achieve this, hence why they are lowly rated, and tend to make poor investments over time.
Now, of course, we are aware that higher oil prices change the economics of oil companies and that there has been under investment in the field which tends to yield to higher returns on capital employed down the line. At the same time, massive capital expenditure would be required. Would we really want to take the risk that oil prices will remain elevated in the long term? What about factors such as climate change or renewable energy? Are these targets all going to be abandoned now? Clearly execution risk remains heightened.
Similarly, for banks, even in the best of times, the returns on assets for such businesses is not great, hence the need to employ a lot of leverage to eke out palatable returns on equity. Should we now overlook this fact and the headwinds from innovative fintech players and challenger banks that are nibbling away at the market share of the high-street banks? Should we invest money on the assumption that interest rates are going to mean revert and remain much higher than they are for a sustained period?
Our industry has a habit of over complicating matters, yet as Peter Lynch describes in simpleEnglish:
“Behind all the smoke and noise on the market’s surface, it’s important to remember that companies — small, medium, and large — make up the market’s backbone. And corporate earnings drive stock prices.”
An (admittedly very quick) glance at the Bloomberg terminal revealed that, for the year ended 2005, Royal Dutch Shell generated $306 Billion in revenue and had a net income of $25 Billion. Fast forward to 2021, RDSA generated $261 Billion in revenue, and had a net income of $20 Billion. Over a 15-year period revenue figures and profits were down.
Investors need to ask themselves if they could fully own any business in the world, would they want to? If the answer is no, they should not want to own shares either.
Many value investors argue that quality stocks are overvalued on the basis that they are higher rated, yet they fail to grasp that they generate shareholder value. Furthermore, there are other legitimate reasons behind the premium rating.
Whilst the market rightfully tends to assign quality companies with a premium compared to the index, quality outperforms over time because the quality factor is seldom fully priced in due to these types of companies being misunderstood by the large cohorts of the market. The chart below, which covers the period from 1988 to 2014, has been purposely selected as many perceive quality outperformance over these last few years to be an anomaly due to the low interest rate environment.
The volatility we are currently experiencing in the market will most certainly make the majority, perhaps even the most seasoned, of investors uncomfortable, yet here lies the opportunity, according to Sir John Templeton, “When people are desperately trying to sell, help them and buy. When people are enthusiastically trying to buy, help them and sell."
Sir John Templeton further explained that: “The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell”.
It will be foolish to try and speculate on the duration of the war in Ukraine; on how persistent and acute inflationary pressures are going to be; in what way the central banks will respond; and in what manner the stock markets will react to all these factors. The answer is that we do not know and anyone who claims to know is either trying to fool others or themselves.
What we can say with a high degree of confidence, however, is that valuations for most companies we are invested in right now are compelling, among the best we have seen in the last decade. This is the overriding factor and gives us great optimism on a medium-term timeframe.
When buying great businesses, time will always be your friend.
The fact that everyone is so bearish just makes me more bullish!
Malcolm Schembri
Fund Manager, EPIC Global Equity Fund