Commentary

This week the International Monetary Fund warned of a “widening disconnect” between geopolitical uncertainty and stock markets, hinting that valuations have become disconnected from reality. This follows similar such warnings in the last couple of weeks from the UK Financial Conduct Authority and the Bank of England.

Given that financial markets appear full of optimism, it left me wondering if now is a good time for investors to be heeding these warnings?

As I reflected on this I began to feel like Corporal Jones, in the very British comedy Dad’s Army[1]. Jones can be relied upon to work himself up into a veritable frenzy, with the joke being that he repeatedly tells others “don’t panic don’t panic” whilst being the only person in the room to show any concern whatsoever about the next impending calamity.

The extreme market moves in August served as a stark reminder of the fragility of financial markets, and how little is really understood about the liquidity that underpins them. Time will tell if it proves to have been the “canary in the coal mine” for a deeper market panic, but having the FCA, IMF, and Bank of England all reference it is a sign that it definitely “rattled their cages”.

Nikhil Rathi, the CEO of the FCA, delivered a speech[2] at the start of October titled “Predictable volatility”, where he expressed the view that “things that used to be one-in-10-year events now happen every month”. He specifically spoke about factors beyond “familiar geopolitical concerns”, highlighting the growing role of technology, increased concentration in both stock indices and the financial system, tougher liquidity conditions, and increased interconnectedness, as sources of risk. His view that “new systemic risks” need “deeper examination”, is a concerning reminder that even those responsible for regulating financial markets struggle with their growing complexity.

The chart below[3] is from the IMF’s Financial Stability Report and illustrates the focus of their concern. It shows how they simultaneously see a very high level of geopolitical uncertainty, whilst financial market volatility is close to an all-time low.

You would have to be living in a cave to not be aware of the sources of rising geopolitical tension, but equity markets appear to have largely “shrugged them off” as not relevant. As I wrote this piece, headlines emerged of North Korea sending troops to fight in Europe – Ukraine still being a European country. I never imagined reading such a headline in my lifetime, yet this genre of news seems to be judged as far less attention worthy than AI powered robotaxis. Don’t Panic!

The minutes of the Bank of England Financial Policy Committee in October[4] stated that equity markets were at “stretched” valuations, leaving them “susceptible to a sharp correction”. They specifically highlight that hedge fund shorting of US Treasuries reached a new $1 trillion high, and the risk that a disorderly unwinding of this could disrupt markets. They went on to discuss “pockets of vulnerability among highly leveraged corporates, including private equity backed businesses” and “challenge faced by corporates that need to refinance their debt”.

S&P estimates[5] that there will be $7.3 trillion worth of corporate debt that needs to be refinanced in the next three years. For investment grade “BBB” credit, they estimate that borrowers will see their finance rate increase by around 2%, given that most maturing debt was issued at a time of record low interest rates. The task many companies face is to both find someone willing to lend to them, and then be able to meet the subsequent higher interest costs. That much of this activity has moved outside the purview of public markets, and the “constipation” within private equity when it comes to selling investments, add to my discomfort.

The chart below shows the debt to GDP ratio in the US since 1952, broken down by category of borrower[6]. The picture looks the same for most other developed market countries, which is that debt levels are at record highs. As these borrowings get refinanced at higher rates, more money is required to service the debts. This story isn’t new, and I am sure you will have seen variants of this chart before. Nonetheless, the “problem” isn’t going away, and in the years ahead I see a risk of lenders being shortchanged by defaulting borrowers, long-term inflation, and or financial repression.

There are multiple top-down ways in which I can show that parts of the equity market look expensive versus history. The chart below is Robert Shiller’s Cyclically Adjusted Price Earnings Ratio[7] for the US equity market, highlighting just how expensive it appears relative to historic earnings. On this basis the only times when the broad market has been this expensive are 1929 and 2000. Don’t panic!

I am all too aware that using a measure, such as this, to warn of impending doom makes me the Corporal Jones of the equity markets. This, and similar metrics, have been elevated for long enough that they are normalised, and so don’t appear to be reason for panic. Ink has been, and will continue to be, spilt on why this is so. Perhaps it isn’t so extreme due to a nuance of accounting, or perhaps the Federal Reserve will now always backstop markets such that valuations have reached a “permanently high plateau”. I believe that only time will tell if “this time is different”, but that it seems dangerous to assume that it must be so.

Switching to look “bottom up”, the next chart shows the average price earnings ratios of two groups of four companies that I picked from the S&P 500. I deliberately didn’t label them “growth” and “value”, but “Group A” are example holdings from growth portfolios, and more generally popularly owned, whereas “Group B” are not. All eight companies are businesses that I admire, and at the right price would consider owning. None are currently in our portfolio (but don’t read too much into this).

Group A contains Microsoft, S&P Global, Cost Co and Stryker Corp. Group B contains Deere & Co, Exxon, Target and Home Depot. Although somewhat arbitrary, I picked them as examples of the extreme divergence of valuations that we see at the coal face in our day-to-day work.

The chart illustrates how the valuations of companies that I view as popular amongst investors, have diverged from those that are not. Is it the case that the best days for “Group A” lie ahead of them, whilst “Group B” are on a glidepath to extinction? The gap in valuations suggests this to be the consensus view.

Although I cannot know which of these companies represents the best investments, clearly those in Group A have a much higher hurdle to clear in order to deliver on current expectations. In my opinion there is a distinct risk that many portfolios will find themselves concentrated towards the most expensive parts of the market, whether this be due to the use of passive products, or active funds that have laid down strong track records by investing in these areas.

Corporal Jones’ colleague, Private Frazer, would, I am sure, have been a value investor. His prognosis for most situations was that “we’re doomed”. As tempting as it is to reach for me to reach for this conclusion, I do not think it to be the case (if it were I certainly wouldn’t have almost all of my net wealth invested in the Havelock fund).

You can construct a version of the future where an AI productivity boom means that we aren’t doomed. High levels of economic growth could shrink levels of indebtedness, and justify the stretched valuations of many stock market darlings. Although possible, I think it unlikely.

The reason why I think we aren’t doomed is because there are many parts of financial markets that are out of favour, such that valuations look reasonable. In some areas this is in turn driving underinvestment, such that I believe the stage is set for scarcity to actually lift returns on capital.

Our approach of understanding companies from the ground up, and only investing when the valuation appears to offer a margin of safety looks, much like Dad’s Army, old fashioned. Prices appear to be increasingly anchored on short-term news, at the expense of long-term prospects. A simple example of this being “cyclical” businesses, where it clearly makes little sense to focus intently on just a single year’s earnings.

A further part of our approach is to try to create a portfolio that can weather storms, rather than one that is configured to expect only fair weather. This approach served us well in 2022, and the market dislocation in August was a clear reminder of why it remains relevant. To this end, we have researched and invested in several new ideas that we think of as “anti-fragile”. These are investments where we believe that chaos in the world order could see their valuations move higher. We don’t pretend to be able to predict how or when this might happen, but view them as a welcome form of diversification.

An example of this is a US natural gas production company. Thanks to the shale boom, US natural gas is the cheapest molecule of energy on the planet, and has helped reduce CO2 emissions by displacing the burning of coal. Due to a continued ramp up in US export capacity and demand from AI data centres, the market has the potential to move into a supply deficit in the years ahead. Given this and a modest valuation we see it as an attractive investment. In the scenario that global energy markets are severely disrupted it would become only more attractive.

The underinvestment in the energy sector is characterised by the MSCI World index having a 3.9% weight in the entire energy sector, versus 4.3% in each of Nvidia and Microsoft. This mirrors other capital-intensive sectors that have been starved of capital. This creates scarcity, which is something that we think can underpin long-term value.

Clearly the approach that I advocate draws us into certain out of favour areas, which creates discomfort. This is in stark contrast to many portfolios that are invested solely in the most popular parts of the market. This squarely includes passive investing, where right now the largest allocations are to the most expensive companies. I believe that the prolonged period of rising valuation multiples has left many investors thinking that this conventional approach is without risk.

John Maynard Keynes said that “worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally”. It is thus that most investors won’t panic until it is too late.

Our current portfolio has a price earnings ratio of 12x, and a ratio of just 10x against expected earnings for next year. Whilst providing no guarantee of success, it means that we don’t need to be investing with unbridled optimism, because we are not reliant on unprecedented levels of earnings growth or multiple expansion. I don’t think we are doomed, but I think a little more panic might prove wise!

[1] https://youtu.be/nR0lOtdvqyg

[2] https://www.fca.org.uk/news/speeches/predictable-volatility

[3] https://www.imf.org/en/Blogs/Articles/2024/10/15/how-high-economic-uncertainty-may-threaten-global-financial-stability

[4] https://www.bankofengland.co.uk/financial-policy-summary-and-record/2024/october-2024

[5] https://www.spglobal.com/ratings/en/research/articles/240729-credit-trends-global-refinancing-update-q3-2024-near-term-risk-eases-13198445

[6] https://www.federalreserve.gov/releases/z1/dataviz/z1/nonfinancial_debt/chart/#units:percent-of-gdp

[7] https://shillerdata.com/

The evidence is that the average active fund has produced disappointing results for investors.
This means that to be an active fund manager you either need to believe that you are better
than average or brazenly ignore reality. Not being one to put my head in the sand, I spend a
lot of time thinking about our sources of “edge” that I think make us better than average.

For us to deliver outperformance, this edge needs to be big enough to cover the fees that we
charge, as it is the combination of edge and fees that determines if a fund has “alpha”. The
fact that the average active fund has historically underperformed passive equivalents, is as
much a reflection of fees being too high as it is managers struggling to “beat the market” with
their investment decisions. It is this thinking that informed our decision to cap the fees that
the fund charges.

The disappointing record of active management is rationalised in the academic community
with the “efficient market hypothesis”. This is the idea that all available information is rapidly
assimilated into market prices, such that beating the market isn’t just hard, but is impossible.
The theory relies on lots of information wonks diligently reading annual reports, and the like,
such that share prices immediately reflect their collective wisdom.

Whilst I don’t believe the efficient market hypothesis to be true, it is a good approximation.
Where the argument for markets being efficient gets interesting, is that as more money flows
to be invested passively, there will be fewer people crunching the numbers. This then means
that prices should be less representative of “all available information”, making it is easier to
have an edge.

The famed “quant” Cliff Asness recently penned an opinion piece1 where he makes the case
that markets have become less efficient. Asness specifically states the case for there being
more opportunity to profit from value investing, based on evidence of market prices being
more disconnected from underlying corporate results. He puts forward three possible reasons
why this might be so:

1) The rise of passive investing.
2) Very low interest rates.
3) The negative impact of technology (or “gamification” of markets).

His view is that it is actually the third of these that is driving a reduction in market efficiency,
and the quotes I provide below are my attempt to give you a succinct summary of what he
wrote (the emphasis is my own).

“Imagine some fraction of the market passively hold the index and the rest are active traders/investors trying to outperform. Now divide this active group in two (this is the obnoxious part). One group are sharks, the other minnows. Minnows make bad decisions based on emotion, story, tastes that are not relevant for risk and return, and behavioral biases. Sharks outperform by taking the other side of the minnows’ misguided positions. Well, if indexing has grown, whether this has made markets more or less efficient comes down to whether more sharks or more minnows moved to indexing. If more sharks have moved, the remaining sharks should have an easier time making money over the long term as there is less competition in betting against the minnows, but the minnows have more influence than they used to at the short to medium term. Prices are a dollar-weighted average of opinions, and if a larger fraction of this is misguided, so will be prices.”

“I think the rise of indexing and the super low interest rates of the last 10-15 years may have had exactly this effect (more crazy, and crazier, minnows, fewer rational G&D [Graham & Dodd[1] / value] disciples), but I conjecture that’s a relatively small part of the story. I’m far more certain that social media, the overconfidence that come when people think all the world’s data is at their fingertips, and gamified, fake-free, instant, 24/7 trading has done so in a significant way.

“Put simply, it should be more lucrative for those who can stick with it [value investing] over the long-term, but also harder to stick with. More lucrative seems obvious. If the rational active investor makes money from the minnows making errors, then they should make more if those errors are generally bigger. But, it also seems obvious that it’s harder to actually do. The periods of underperformance will be more severe and last longer.”

Whilst this story clearly “suits my book”, it also resonates with what we observe. After six years of running the fund, I am more convinced than ever that “time horizon” is one of our major sources of edge. This is as much about focusing on the likely long-term earnings power of a business, as it is about owning them for extended periods.

I believe that many corners of the market are increasingly short-term, and not driven by a rational appraisal of fundamentals. This creates opportunity, but as Asness says, trying to capture it makes for an uncomfortable ride. In order to stay the course, you have to have done enough homework, otherwise the first bump in the road will leave you wanting to capitulate.

By way of example, one of our holdings went up 54% during the last quarter, only to fall back by 26% in the final week. Without getting into the weeds, it is hard to see that this level of volatility was justified by the news coming out of the company, with management reaffirming their guidance for full year profits. It is however a company with a relatively high level of retail ownership, and we believe that this price action has been driven by these folk more than the professionals who own it.

Although I give an extreme case, we often see a level of stock price volatility that appears disconnected from any reasonable interpretation of the facts. I believe that this is because of the dominance of people who aren’t acting based on long-term fundamentals.

Clearly my views, and those of Cliff Asness, argue in favour of fundamentals driven value investing having at least some weight in your portfolio. I increasingly view it as a “time horizon arbitrage”, but this means that you need to be willing to judge the results based on years and not months.

---

[1] Ben Graham and David Dodd wrote the definitive value investing book Security Analysis in the 1930s.

Our modus operandi is to be bottom-up investors, studying companies that we think might make for overlooked bargains. This, however, doesn’t entirely free us from thinking about the bigger picture both within markets and the world at large. As we zoom out from “micro” to “macro”, we have to make do with abstractions as the complexity of the real world otherwise becomes overwhelming.

One such abstraction is “value” versus “growth”. Although it seems absurd to categorize 1000s of companies as either displaying one characteristic, or the other, it is a simple and convenient approximation of two different investment approaches. I, like many other value investors, have been quick to highlight the increasing premium that investors have paid to own “growth”. This is shown below by the price earnings ratios of the MSCI World Growth and Value indices.

The chart shows that investors have been willing to pay an increasingly high multiple of earnings for the growth index in the last fifteen years. This “multiple expansion” has created a performance tail wind for growth investors, that has left many companies looking expensive relative to history.

The big question is what does this mean for prospective future returns? Does “growth” face a prolonged period of underperformance versus “value”?

I see three possible explanations for the current high premium being paid for growth, each of which would lead to a different conclusion about the future:

• There is a rational reason why investors are paying such a high premium.
• Investors aren’t paying a high premium, because price earnings ratios misstate it.
• The high premium is irrational.

Prior to 2022 “conventional wisdom” suggested the elevated premium for growth stocks was rational, because interest rates were so low. For the benefit of readers who live in a cave, the argument was that earnings in the distant future had become more valuable in terms of “today’s money”, implying a “bird in the hand” was worth “one in the bush” and not “two”.

Given today’s higher rates, the interest rate justification for this premium isn’t credible. Could it be that the premium has increased this year because markets are “discounting” interest rates falling back to previous levels? Given that the growth index price earnings ratio is higher than at most times when rates actually were close to zero, this argument seems like a stretch.

There have been, and will be, other rationalisations for the premium. For example, that Generative AI will unleash a new wave of earnings growth for a select group of companies. I haven’t seen an explanation that I find credible, but it doesn’t mean that one doesn’t exist.

The second possibility is that an analysis based on price earnings ratios is misstating the premium. This argument holds more sway with me, as “earnings” are a complex and somewhat artificial construct. For example, many highly valued companies derive their earnings from intangible assets, and it can be argued[1] that accounting rules tend to understate profitability in this instance.  Similarly, a recent paper[2] used a measure termed “economic profits” to show a small group of large companies making an outsized contribution, but did not venture onto what valuation investors should pay to own them.

Given that the growth index is also at an historically high premium based on price-to-cashflow and enterprise-value-to-EBITDA ratios, I am sceptical of “new paradigm” type explanations. I do however accept that price-earnings ratios, or the style indices themselves, might be misrepresenting the size of the premium that investors are paying for growth companies.

The third explanation is that the high premium is irrational, and that it represents a “bubble”. Clearly, we all rationalise things differently, and so perhaps what is irrational to me isn’t to others?

My preferred explanation is that the high premium is the product of governments and central banks underwriting risk in markets. Again, for the benefit of cave dwelling readers, the 2008 crisis was handled by “pumping” liquidity into the financial system, with central banks using newly created money to purchase financial assets. The majority of these assets were government bonds, and so the net effect was both to raise asset prices and put money into government coffers. The same approach was repeated during the COVID crisis. The chart below shows US non-financial debts since 1948, broken down between government, households and companies. The chart for the UK looks very similar, but I focus on the US given its dominance in financial markets.

This chart tells multiple stories. It shows the rapid build-up of household debt prior to the 2008 financial crisis, and how the subsequent deleveraging came at the expense of increased government borrowing. It also shows how the shortfall in economic activity during the COVID crisis was funded by a second large increase in government debt.

I believe that the net effect is that most investors have rationalised paying a large premium for the most successful companies, because it appears that central banks will intervene in the event of a large market decline. I do not assume this pattern of “privatised gains” and “socialised losses” must continue, but I can see why others would.

The previous chart also shows how all three categories of borrower have become increasingly indebted over the long term, such that total debt levels in the economy are at a post-war high. I believe that this lies behind many of the political challenges that we currently see, but that is a story for another day!

Economist, Hyman Minsky, theorised that long periods of prosperity and investment gains encourage diminished risk perception and a build-up of debt, that will ultimately end with a “Minsky Moment” collapse in asset prices. The build-up of debt in the world’s major economies is without doubt, and I think that the high premium investors are willing to pay to own growth companies is one of many pieces of evidence that suggest a diminished perception of risk.

The different interpretations of the high premium currently being paid for “growth” would lead to different conclusions about the future. If the premium is rational, or non-existent, then there is no reason for concern. If on the other hand it is irrational, investors in the most expensive companies will likely experience future returns are at best disappointing and at worst stomach-churningly awful.

It would be bold to say that you believe any one of these explanations with complete certainty. I prefer to think in terms of probabilities, and I put a higher likelihood on the premium being irrational, but accept that it is also possible that one of the first two explanations is correct. Only if you are very confident that the high premium is justified, should you be “all in” on growth.

Many investors will draw the conclusion that they wish to guard against the risk of a fall in asset prices by owning the highest quality assets, but this ignores the price paid to purchase them. This approach didn’t work in the late 1960s and early 1970s, when investors in blue chip “Nifty Fifty” companies were subject to a subsequent decade of disappointing returns[3].

Returning to where I started, “value” and “growth” are crude abstractions of a complex reality. The high price earnings multiple for the MSCI World Growth index is driven by individual companies, like Nvidia, each of which will have their own narrative. In the same way that not all “growth” stocks will be overvalued, not all “value” stocks are sub-par duds.

I think that it is the combination of the quality of what you own, and the price you pay, that will best guard against loss of capital.  This is the approach that we use, and I believe why we were able to sidestep the large falls in asset prices during 2022.

I do not know what will happen next, but the amount of debt in the world’s major economies puts us in unchartered territory. For this reason, I think it is dangerous to assume that the “status quo” in markets must continue. My best guess is that central banks and governments will sooner, or later, pull back from underwriting the risk of investing, which will place a renewed importance on valuations.

Matthew Beddall

CEO and Fund Manager, Havelock London Ltd

---

[1] https://www.morganstanley.com/im/publication/insights/articles/article_intangiblesandearnings_us.pdf

[2] https://www.morganstanley.com/im/publication/insights/articles/article_stockmarketconcentration.pdf

[3] https://www.clearfinances.net/nifty-50-bubble/

The grandfather of value investing, Ben Graham, famously said that “in the short run, the market is a voting machine but in the long run, it is a weighing machine”.

What Graham meant is that in the long-term market prices move to reflect the economic fundamentals of companies, whereas in the short-term they are dictated by the whims of market participants. By “economic fundamentals” I really mean the earnings that a company generates for shareholders, as measured by either the rules of accounting or cashflows. Graham’s opinion that prices move much more than is justified by earnings was validated in the 1990s by the academic Robert Shiller, for which Shiller was later awarded a Nobel Prize.

The chart below shows the relative expensiveness of “growth” versus “value” companies, US versus non-US companies, and large versus mid-size companies[1]. The lines tell us the extent to which investors are currently willing to pay a premium to own the former, over the latter.

This shows that the premium to own growth companies, US listed companies and large cap companies appears to be as high as it has ever been in the last 30 years. As value investors we think this trend is more likely to reverse than continue.

We believe these premiums are the product of the “voting machine”, with the enthusiasm that many investors have for certain companies running well ahead of a reasonable expectation of their ability to generate earnings. The counterargument, based on the “weighing machine”, is that the premium investors are paying is because a select group of companies are likely to grow earnings at a much faster pace than they have done historically.

Our portfolio is not just focused on value companies, but is currently also exposed to non-US listed mid sized companies. This is because it is where we see opportunity. The fund has made money in each of the five calendar years that it has been running, but the trends that I describe mean that its relative performance has faced multiple headwinds. If these trends reverse, the fund stands to benefit, as they should move to become tailwinds to our performance. We cannot know if, or when, this might happen, but we believe history is on our side.

In short, we believe our fund provides exposure to the “weighing” machine, not the “voting” one.

Appendix

The table below outlines the data that was used to produce the chart:

We used price earnings ratios based on 10-year average inflation adjusted earnings, as this removes the “noise” of individual years’ earnings. We also produced charts based on the prior year’s earnings and prior year’s cashflows, which show the same overall trends. These are shown below:

---

[1] The MSCI World size indices have a limited history, and so the size factor uses just US data prior to 2009.

The performance of American public equities since the Global Financial Crisis has been exceptional, with the result that they account for more than 70% of the MSCI World index. This is demonstrated in the chart below, that shows the relative returns of owning American equities versus other developed markets.

The chart also shows that there have been periods of time when the reverse has been true, with the returns from US equities lagging the rest of the developed world during the 1970s and 1980s. This pattern of prolonged periods of under and over performance held for the entire twentieth century[1], despite the long-term trend of US dominance versus “old world” economies.

The technological revolution that we are currently living through has very much been centered in the US, meaning that it has spawned many of the world’s largest and most profitable companies. The outperformance that is shown above tells us nothing about the growth in earnings power in US companies, and the extent to which it has also outpaced the rest of the world.

The MSCI US index currently has a price-to-earnings ratio of 25x, versus the MSCI World index ex US having a ratio of 15x. This tells us that US companies look more expensive than their developed market counterparts, based on their previous year’s earnings. On this basis, the US index has become progressively more expensive in the last decade, which is only rationalised by a growing belief that future earnings have much higher growth yet to come.

The “Magnificent Seven” companies account for 28% of the MSCI US Index, and so have become the focal point for US equities. They have been the driving force of strong earnings growth, strong share price performance and high valuations. The next chart shows the average net profit margin for the group of seven, which is the fraction of their sales left over after they have paid all operating expenses, finance costs, and taxes. On this basis these companies have never had it so good.

The average price earnings ratio for the Magnificent Seven is 37x last year’s earnings, meaning that they appear markedly more expensive than the MSCI US index on 25x earnings. To justify this valuation, they either need to see strong sales growth or increase profit margins[2]. At their current size, growth in relative terms corresponds to large quantities of incremental sales in absolute terms, which is a challenge. Likewise, growing margins from current peak levels will also be a challenge.

I cannot know that the premium investors are currently paying to own US equities, and specifically the Magnificent Seven, will not eventually be justified by higher earnings. What I do know is that because much growth is already “priced in”, there is a substantial risk of disappointment if they fall short. The dominance of these companies means that many portfolios will, like the passive MSCI World index, have a concentrated exposure to this risk.

The next chart shows the price to ten-year average inflation adjusted earnings for the MSCI World and MSCI World ex US indices. This tells us that if long term average earnings were to be a good guide to the future, then US equities currently look very expensive. For the Magnificent 7 this ratio is, on average, 65x, making them look more expensive still.

We do not want to rely on optimism, and are particularly cautious about requiring record-high profit margins to justify an investment. We see plenty of opportunities where only modest expectations for the future are required, for valuations to be attractive. This “glass half empty” approach means that we do not currently own any of the Magnificent Seven, despite the fact that they are attractive businesses. Put simply, we believe a good business only makes for a good investment at the right price.

Source: All data used in charts and commentary is sourced from Bloomberg.

[1] See https://globalfinancialdata.com/the-united-states-or-the-rest-of-the-world

[2] They can also grow earnings by buying back shares, but this is not very value accretive at current valuations.