I’ve just started slowly preparing for a new book called In Search of Alpha. My mission is to talk to successful fund managers who are properly active and understand what’s the key to their process. In reality, the book is about people, behavioural science and the way that processes are built over time. Some of the investors which will feature in the book are growth orientated, others value – the book isn’t really about the primacy of one over the other.
But if I’m honest I do find myself instinctively drawn to ideas that emerge out of value investing. In particular two concepts seem attractive. The first is that when you buy a share you are buying a stake in the business, and thus you need to understand the fundamentals if that business. The second is that careful selection of good businesses that most people dislike is probably a good idea – though risky.
This week, I bring you two takes on the art of investing. The first is from Greg Fisher, who runs the Halley Asian Prosperity Fund which I have written about before in both the FT and Money Week. Greg is a proper Ben Grahamite and has spent the last few years chugging around the Far East – and especially Japan – in search of great, cheap stocks. He has an excellent track record and also produces erudite monthly investor reports – I feature one passage from this month’s report below.
The other section is from the always readable and controversial Andrew Lapthorne, chief quant strategy guru at SocGen. Andrew works alongside Albert Edwards although I think it is fair to say that he is slightly less bearish overall than the great perma Bear himself. Maybe that’s because he spends his time carefully monitoring different investment styles – and running indices which are tracked by successful ETFs. Anyway, I’ve featured a lengthy passage from his latest style review at the bottom.
The message from both is that if you are a contrarian and value type, you should be feeling more than a bit nervous about stock markets at the moment.
First up here’s Greg on style investing and equities. Note the end conclusion – in bold (my emphasis).
If there was a true opposite to ‘value’ as an investment philosophy, it would not be ‘growth’. It would be ‘expensive’. After all, our ‘value’ stocks have ‘growth’. This is becoming clearer in a world where there is, in fact, less nominal economic growth, but at the same time evidence that certain companies can for short or long time periods, generate higher margins than other companies. ‘Super-normal’ margins inevitably disappear over time unpredictably- so the question always is, how much am I prepared to pay for this corporate advantage, while it lasts? 30x earnings? 50x?10x book? 25x? How much will others pay, and how long will the margins last, the ‘moat’ remain defensible? (note how this is the exact opposite of waiting for a revaluation of an under-priced business, where there is no cliff-face of disappointment, because there are no expectations).
As someone who has been visiting companies for some time, an essential part of my job is to try to analyse businesses to understand that there is sufficient quality in the franchise to believe that present margins are at least sustainable. This then goes alongside equally important efforts to understand the value of company assets, capital allocation, governance etc. My own experience is (and this is not meant to be self-deprecating, just an honest personal observation) that of everything I do, judging the true long-term sustainability of margins, is the hardest of all, when doing research on companies. It is extremely difficult.
There are just so many factors to consider, not to mention unpredictable risks/changes to model. And when you are looking at large cap stocks often heavily over-researched- are you really a better analyst than the other millions of fund managers researching Alphabet? Why, exactly? I am therefore personally very suspicious of those many individuals who claim this skill. But I am even more suspicious when it stands loud and clear as the core ‘philosophy’ (what a misused word) of their investment approach,
underlining their supposed ability and pure focus to pick business ‘winners’ with such ‘moats’. That said, undoubtedly, a few can, whether the result of coin-flipping or not. Just look at the 5 year track record, beloved of all marketers (Don’t look at the fund
metrics, they will be scary, a disaster to come). Worst of all, however, is when this approach becomes an investment industry consensus, as a result of stocks falling into this, say, US/global megacap category, outperforming for a period of 5-10 years (the
last 5-10 years) and thus being re-rated already to eye-watering valuations, helped by the rise in indexation. Any longer term history tells us that to trust investment managers treading this presently over-populated path, will not lead us to solid or indeed safe returns in the future. Quite the reverse, especially in already expensive stock markets, particularly such as the US. I don’t believe the US market is today as crazy as it was back in 2000, but you would have to be more than just crazy to buy into a high P/E, super high price/book US equity fund at this moment, unless you were
just a momentum fund riding a wave until it crashes, then going short, systematically. Dangerous isn’t strong enough a word. Better, surely, from a probabilistic point of view- forget whatever stories are told about ‘great US companies’ or ‘secular/sectoral
growth trends’ -to invest in genuinely cheap businesses, at or below book value, with high return on equity and increasing dividends, no debt? Just buying ‘fantastic businesses’ is a recipe for disaster, without a strong sense of value. That, is what allows us to claim to try to produce acceptable absolute returns, and to protect the safety of our capital. Buying ‘super-normal’ means taking risk, lots of it. ‘Expensive’ is not how we do our shopping.
Next up, I have Andrew Lapthorne and his regular updating of different factor investment styles – and their performance year to date. Note the warning at the end.
That Growth stocks are globally the best performers this year is perhaps surprising, but not unusual. Growth is typically favoured as the economic cycle enters its twilight years. The difficulty is getting out before the downswing, as Growth tends to suffer most in down markets. And given that it is now the most expensive of all the factors, this is all the more critical. Value it must said has been a disappointment this year, especially after last year’s surge upwards and with many expecting better economic times ahead. Instead, Quality and the bond-proxy cabal have, alongside actual bonds and gold, had a surprisingly good 2017.
Driving this rotation away from Value and back towards Growth and Quality has been the US. The underperformance of one of our favoured Value metrics has been as bad as it was in the Tech boom, perhaps worryingly indicating an equivalent willingness to ignore valuations. Yet it is in the US where we continue to see the greatest risk aversion, particularly in regard to balance sheet risk, where it remains this year’s standout factor in both the S&P 500 and the Russell 2000.
Europe has been much more mixed. Value has made small gains and with their lower overall leverage ratios, balance sheets do not appear to be an issue for European investors. Price momentum has been the best performing factor. This is not particularly bullish and this trend seems to have emerged post the French election, at a time when European markets have largely been going down. Corporate balance sheet risk is also a non-issue in Japan. Japan remains the cheapest region and the Japan Value factor is cheaper than either the US or European Value factor having spent almost 30 years getting there. But Value is not favoured in Japan either, where once again the focus has been on profitability and not on Value. Confirming what we see in other regions, namely that factor-wise, investors are increasingly bearish.