Dark Days for Contrarians
Piet Viljoen, Executive Chairman
19 May 2015
'That's really the main effect QE has – to encourage yield-seeking speculation that drives up the prices of risky securities, but without having any material effect on the real economy or the underlying cash flows that those securities will deliver over time.'
'Ultimately they lead us most importantly to the prospect for future asset returns, which if 0% real is the New Neutral in the U.S. and correspondingly lower elsewhere, speak to an inability of savers and investors to earn sufficient returns to satisfy presumed liabilities. If real rates continue to be so low, then discounted income streams are dependent solely on growth and/or inflation instead of capital gains, which in the prior three decades have been substantially influenced by the decline in real rates. The lower real rate/capital gains ocean liner has taken us into uncharted waters, but waters, which we must know, that are hostile to investors.'
'Sept 2013 (All-Share index = 43,752) was the first time in the survey's history that 100% of managers viewed the market as 'overvalued' and 100% saw more Sells than Buys. At the close of this month's survey, the All-Share index stood 22% higher than in Sept 2013, earnings are 17% higher and the PE is 0.5 multiples higher.'
Merrill Lynch Fund Managers Survey, April 2015
'Two new market participants seem to be driving this multiple expansion: "smart beta" and pension funds. The GPIF and its smaller brethren are rapidly shifting their portfolio allocations from bonds to equities and, in the process, are searching the equity markets for companies with duration. This isn't easy as only 2% of companies survive 30+ years on the Darwinian savannah. "Smart beta" is not a concept which we find easy to comprehend. It has its background in the same basic criteria that attract the pension funds, but with added emphasis on high dividend yield and low volatility. The underlying principle for both groups is that a P/E of 30, which is equivalent to a earnings yield of 3% or a P/E of 50, equivalent to an earnings yield of 2% , are far more attractive than a ten year bond yield of 0,4% or negative yields at shorter duration. Life is rarely as straightforward as implied by this analysis. One wide-ranging analyst has been joking that the logical price for equities in this environment is infinity, perhaps reminiscent of the Zimbabwean monetary hyperinflation. While the trajectory of this trend is unclear, its short term effect is obvious.'
Scott Gilchrist, portfolio manager of the Platinum Japan Fund
'We are fast reaching the point where markets are crossing the event horizon, where mathematical investment analysis no longer makes sense. We read that some 25% of bonds in Europe now offer negative interest rates. How do your value equations work in an environment of negative yields? It becomes mathematically impossible for pensions and insurance companies to meet their goals, given their investment mandates, in a world of negative interest rates. While economists may applaud negative rates, those who will need their annuities and pensions are probably not yet aware that their futures have been mortgaged for a set of narrow economic goals, which look as though they are not being fulfilled at any rate. When the bill comes due in 10 years, those in charge today will have moved on to other more lucrative opportunities, and pensioners will realize how screwed they have been.'
In recent times, a bifurcation in the stock market has come about. A certain subset of the equity asset class has come to be seen as riskless growth assets, while another has come to be seen as return-less risk. The former are represented by the equity in companies which are defined as having some sort of 'quality' aspect, which protects their earnings from erosion through competition. Such companies can also be called long duration assets due to the longevity bestowed upon them through their 'barriers to entry'. The latter are companies which are beholden to the economic cycle and periodically struggle to produce any earnings at all.
Financial markets love nothing more than extrapolating a good story and developing product to sell on the back of these extrapolations. Yesterday it was resource stocks on the back of the commodity supercycle, the day before yesterday it was tech stocks on the back of the TMT revolution and today it's exchange traded funds that mimic popular indices triumphing on the back of the inability of active managers to outperform these indices. The intuitive logic of buying and holding good quality stocks forever supports this trend. 'Smart Beta'1 has truly won the hearts and minds of pension funds and, importantly, their trusted consultants – walking and talking like a long-term value manager. No wonder share prices continue rising, even when 100% of analysts think they're already expensive.
Table 1: Earnings Growth, Share Price Growth and Current Price-to-Earnings Patio (P/E) as at Date of Writing
However, extrapolations only last until they become ridiculous, and the current one is fast approaching that state. Consider the ten constituents of the JSE FTSE All Share Index (ALSI) shown in Table 1.
This table speaks for itself, but a few observations about this (non-random) sample of companies might be in order:
- These are, without exception, good businesses, managed by good people.
- Almost all of these businesses have some form of barrier to entry, which protects them from competition and allows them to earn high returns on capital over long periods of time. As such they are all quality businesses and long duration assets.
- Most of these companies have a large proportion of earnings coming from outside South Africa and the weak Rand over the past few years has benefitted their earnings growth tremendously. It's not clear whether the Rand will weaken by the same rate again over the next four years. In 2011, the Rand was substantially overvalued on a purchasing power parity basis – today, it's somewhat undervalued.
- Together these companies make up 34.7% of the ALSI. Thus, more than one third of the local index is made up of good quality companies with a large portion of foreign earnings. Adding in companies not on this list, but having similar attributes would take the proportion of such companies to a majority of the index.
- From the earnings growth figures shown in the second column, it's clear that these are growing at a much slower rate than share prices (column 3), resulting in very high P/E ratios. On average, earnings have grown by just over half the growth rate of share prices. Clearly, this is not sustainable.
It wouldn't be unreasonable to regard this group of companies as being high risk investments, given the high multiples being paid for muted (constant currency) earnings growth. Remember, investment risk is different to business risk. These are low risk businesses, but high risk investments. To the extent that low interest rates inflate the prices of financial assets and leave the growth rate of the real economy depressed, these investments become even riskier.
It also follows that investors in passive index tracking vehicles are taking on more risk than they think. Again, there is some confusion on what exactly constitutes risk. Some regard it as performing relatively worse than an index (relative risk), others regard risk as actually losing money in absolute terms. We are firmly in the latter camp. Today, many investors regard index trackers as low risk due to their exact tracking capability, forgetting that the thing they are tracking is where the risk lies.
From the discussion above, it should be clear why RECM's portfolios hold almost none of these kinds of stocks. In the short term however, the share prices of these market favourites keep going up as pension fund trustees and their consultants herd their funds into 'quality' assets or portfolios tracking indices that contain plenty of these. This is of course a riskless strategy for them as everyone will be wrong together – a safe space for advisers with no skin in the game. Not so for their ultimate client, the pensioner.
The upshot of this trend, like all the others before it, is that investors are turning temporary gains into potentially permanent losses, while converting temporary losses into permanent losses.
Let me explain. Let's say one holds two stocks. Stock A has had a rising share price as a result of which it has become expensive relative to its underlying intrinsic value (i.e. any stock from the table above). Stock B has had a declining share price and as a result has become cheap. Most investors feel more comfortable selling the poorly performing stock, and buying more of the one which has done well.
Assuming the intrinsic values of both companies are still intact, by selling the cheap one the investor is locking in their loss and making it permanent. In the fullness of time, the market would have realised that the stock was undervalued and re-priced it upwards. The only requirement to extract this uplift – and recover from the temporary loss – is a good dose of patience and an ability to suppress one's natural jealousy of your neighbour who might have owned more of the popular stock with a rising share price!
Conversely, by not selling the popular stock, one accepts the very real risk of seeing it drop at some point in future, as the trend plays out. One would then have lost the opportunity to lock in the previous (temporary) gain and instead suffered a permanent loss. This would be more of a mistake of omission rather than commission, but both types of mistakes penalise outcomes equally.
Investing is simple but not easy and the degree of difficulty is determined by the amount of emotion involved. Seldom before has being a contrarian value investor been more difficult. We hold our conviction that the best protection against permanent capital losses – and against the market manipulation of today's central banks – will be cheap assets. So if one can avoid being forced into 'growth' assets by central bank interest rate manipulation and consultant-driven herding behaviour, we think it won't be long before there are rewards for the few who could stay the course. Rewards that will more than make up for the recent tough times for contrarian investors.
1 So called 'Smart Beta' products are portfolios that passively follow indices where the stock weights are not determined according to the traditional market capitalisation weights, but rather according to another scheme - for example dividends or 'volatility' rankings.