Commentary

The extent to which a small number of large companies supported the major stock index returns in 2021 has been well written about in the financial press. For example, a recent Bloomberg article told how the “number of Nasdaq stocks down 50% of more is almost at a record” with “40% of index’s firms having fallen by half from one-year highs”.

As of writing the 10 largest Nasdaq stocks account for more than 50% of the index, with the largest company, Apple, having recently hit a $3 trillion valuation. Apple is an impressive company, and one that, via Berkshire Hathaway’s holding, we have some exposure to. It has been a clear beneficiary of the lock down economy and has seen a year of “bumper” profits. The chart below shows a history of the company’s net income or earnings, together with the average analyst forecast of the next two years.

The next chart shows the company’s revenue by line of business for each of the last five years. This shows how the “services” revenue has been growing as we all watch more movies and download more apps from Apple. It also shows how sales of their iPhone are the dominant source of revenue, and one that had a big lift in the last year.

Apple’s share price is currently around 30x the value of its earnings. Prior to 2020 the company had spent ten years during which this ratio was almost always less than 20x. Furthermore, its most recent earnings are substantially higher than it has ever seen before, arguably helped by lots of lock-down induced iPhone purchases.

In my experience, it is a fundamental human tendency to like to extrapolate recent history into the future. This makes good sense as it is a good heuristic for many aspects of life. I believe that stock analysts are particularly susceptible to this, with company forecasts for the near future typically being “like last year plus a bit”.

The risk I see in owning a company, like Apple, at its current price is that not only are you susceptible to its price earnings multiple reverting back to historic levels (which would equate to a circa 30% price fall), but to the company struggling to deliver results that match last year’s “blow out” success. This is the type of situation that I am happy to leave to other investors with a more optimistic disposition than my own.

As the pandemic continues into its third year, many of us had to put our overseas holiday plans on hold again in 2021.  Whilst it is sensible to hold off checking whether our swimming costumes still fit until after a January detox, there is no better time to check our investment exposures.

‘Only when the tide goes out do you discover who’s been swimming naked.’

Warren Buffett

The above quote from Warren Buffett could apply to when the tidal wave of liquidity provided by the World’s Central Banks recedes, showing which investors were too reliant on it continuing. We believe that many investors could be found to have been consciously, or otherwise, overly exposed to three specific themes within equity markets; the US, the ‘growth’ style and a small number of large companies.

The US

Without doubt, the US is home to many of the highest quality, most innovative and world-leading companies.  The US weighting within the MSCI World Index stands as an eye-watering 69% as of 30^th November 2021, but only represents circa 25% of 2020 World GDP as the chart below illustrates.

Anecdotally, Japan peaked at 44% of the MSCI World Index in the 1990s and sits at a paltry 6.5% as of the end of October 2021.

Is it the case therefore, that investors in the MSCI World Index, or global funds with a keen eye on their benchmark, are placing disproportionally high bets on the US continuing to outperform all other markets?

The ‘growth’ style

The top 10 company weights by market capitalisation of the MSCI World Index are shown in the table below:

They are all US listed companies, and the top 8 would be categorised as ‘growth’ stocks in the truest sense.  We believe it is overly simplistic to categorise over 40,000 listed securities as either  ‘growth’ or ‘value’, and to then assign specific characteristics to each category, such as ‘high-quality growth’ companies and ‘low-quality, zombie value’ companies.  It is beyond doubt that ‘growth’ has significantly’ outperformed ‘value’ over the last ‘tech-ade’, but as shown in previous articles, the bulk of this outperformance has come from earnings multiple expansion.  After a decade of outperformance, is it the case that investors are over-exposed to ‘growth’ relative to ‘value’, at the exact moment when it appears most expensive?

The same companies

The top 10 constituents of the MSCI World Index (shown above) not only represent almost a fifth of this 1,555-stock index, they also represent circa 30% of the S&P 500 and frequently feature in top 10s of ‘growth’, ‘value’, global and regional funds alike.  Increasingly, many of these companies have also been mainstays of active and passive funds branded ESG or Sustainable, as the table below illustrates:

Is it possible that investors’ portfolios aren’t as diversified as they may believe, as the same dominant, multi-trillion dollar mega-caps are appearing in an increasing number of products?

In summary, after the last ‘tech-ade’, would it be prudent for investors to consider if their portfolios are adequately diversified across regions, styles and companies, so that they won’t risk embarrassment should the tide go out?

The movements of popular stock indices dominate the headlines, and all too often the psyche of investors. Given the large price increases in most stock indices for the year, it is tempting to think that the “opportunity set” for investors has been diminished. This is not, however, what we are seeing.

As of 6^th December, the S&P 500 is up almost 21% for the year to date and only 3% below its recent all-time high. It’s global counterpart, the MSCI World index, is up almost 15% and around 5% below its all-time high. These indices are, however, weighted by the size of their constituents and so their movements do not reflect that of the typical company.

It is the case that many companies have seen price falls far greater than those of the popular indices. The average distance from the high of the last 52 weeks is 14% for S&P 500 companies, and 16% for MSCI World companies. The chart below shows the percentage of companies in these indices, together with the Russell 2000, that have seen large price falls. The chart contains three definitions of “large”, distinguished by the different coloured bars.

The analysis illustrates that almost one third of the companies in the MSCI World index have seen their prices fall by more than 20% from their 52-week high. The Russell 2000 index contains small and mid-cap American companies, is up 11% for the year and is 11% below its all-time high. This index has around two thirds of its constituents now more than 20% below their 52-week high. This all hints at the extent to which recent strong performance in the stock market has been driven by the very largest companies.

The technical definition of a “bear market” is a price fall exceeding 20%, and there are many individual companies that now meet this criteria. A fall in price does not automatically make something a bargain, but with large numbers of companies having seen price declines we believe it improves our chances of finding attractive investments.

A good number of the companies that we follow have experienced price declines in the past few weeks, influenced in part by the list being dominated by smaller “mid cap” companies.

Our job, as active investors, is to ascertain the extent to which these price declines reflect changes in underlying business prospects, versus changes in the animal spirits that we believe also drive markets. Where we believe that a price decline is far more driven by the latter, it gives us an opportunity to make an investment at an incrementally more attractive price.

We believe our opportunity set has materially improved in the last three months because we have seen many companies where the decline in their share price appears out of step with any reasonable analysis of their prospects. Whilst there can be no guarantee that any single investment will play out as per our analysis, we believe that broad price declines tend to tilt the odds in our favour.

One of the cornerstones of our investment approach is to value every business that we own and track. We use these valuations to estimate the intrinsic value of our portfolio, and its discount to current market prices. This gives us a way of quantifying the strength of our opportunity set, from the bottom-up, that we label “excess value”.

This bottom-up “excess value” measure says that we see more opportunity now, than we did at this time last year, having already produced some healthy returns so far in 2021. It is against this backdrop we feel a sense of optimism and, more importantly, have started to deploy some of our “dry powder” cash holdings.

I have written before about my concerns over the optimism that is required to justify the valuations of many popular “growth” stocks. The analysis that follows will further explain why I have these concerns.

The chart below shows the total market capitalisation of the ten largest “growth” stocks, as defined by the MSCI World Growth index. Their total value is expressed as a percentage of the regular MSCI World index. Hence, if you were to purchase a MSCI World tracker fund you would currently have around 17% of your money invested into these ten large businesses (as an aside this compares to UK stocks having a circa 4% weight in the index).

The second, black, line on the chart shows the percentage of earnings that these ten companies represent. Hence, their earnings, or profits, currently represent around 10.5% of the total earnings of all the companies in the MSCI World index.

How should we interpret this disparity between the current market value of these companies and their earnings?

The share price of a company, in theory, represents expectations about its future cashflows to shareholders. Hence, the disparity between the two measure tells us that the consensus view of market participants is that these ten large businesses will grow their earnings at a much faster rate than the other 1,590 companies in the index. This is possible, but given that they are the largest growth companies, it is surely a tall order?

For the curious reader, the table below shows the ten largest constituents of the MSCI World Growth index that were used to produce the chart. Together with their total market capitalisations, the table also includes the total value of shares sold by company insiders in the last 12 months.

Although the value of shares sold by company Directors appear small relative to the companies’ market capitalisations, the proceeds are concentrated in the hands of a very small number of beneficiaries. This represents a transfer of money between purchasers, who will have included retail investors and pension savers, and the people who have an intimate knowledge of these businesses. This leaves me thinking that the empowerment of retail investors could, in fact, be stealing from the poor to give to the rich, rather than the other way around!

As long-term investors, company valuations matter to us, as a great business will only make for a great investment at the “right” price. We cannot know that these businesses will not live up to current lofty expectations, but our approach is to avoid investing when we think the price paid requires undue optimism. Our core objective is to make sure that our portfolio is robust in a range of future scenarios. By managing the risk of financial loss in this way, we believe we can increase our chances of delivering superior long-term compound returns.

In response to the global pandemic central banks and governments have delivered record amounts of economic stimulus. Much of this has taken the form of increasing money supply via buying financial assets, following which asset prices look high relative to their history.

As observed by famed investor Howard Marks, a world with high asset prices is a world of low future returns. This is most easily understood by a traditional bond investment that pays a fixed coupon; higher prices clearly equate to lower income yields. The same argument applies elsewhere when asset prices increase by more than their underlying economics or earning power.

What we do not know is if asset prices are now at a permanently higher plateau, and lower investment returns are the new norm, or if we are witnessing a spectacular “everything bubble” that will create financial pain when prices “normalise”.

Where does this leave investors?

The easiest response is to do nothing and knowingly, or otherwise, accept that future returns will be lower. I believe this is the path of least resistance, and thus the one that most investors will take.

To try and avoid lower future returns, I see only three credible options:

1. Take less risk in the hope that asset prices are cheaper in the future.
2. Take more risk in the hope that the status quo holds, and you earn a higher return.
3. Try to do something “clever” to make a higher return with no additional risk.

Doing Nothing

In investing, doing nothing, is often a good strategy. It allows you to side-step the latest fads, avoid acting on emotions and helps ensure that returns are not eaten up by transactions costs.

In the last decade I believe many investors have navigated towards owning a portfolio dominated by “growth” stocks and government bonds. These have both been the “gifts that keep giving”, however I believe they are destined to produce lower returns in the future.

In the case of government bonds, and fixed income investments more generally, we have experienced 40 years of falling interest rates. This provided a tail wind that helped increase bond prices (since they move inversely to interest rates). In the last decade UK 10-year Gilt yields have fallen from around 3% to 0.5%. I calculate that for investors to receive a similar return in the next decade, as in the last, 10-year UK interest rates would have to fall from 0.5% to around -4%. I think this is possible, but unlikely.

So called “growth” stocks have also benefited from a tail wind in the last decade, with their prices moving to be much higher multiples of their underlying earnings. The price to average 10-year earnings ratio for the MSCI world growth index almost doubled in the last decade, moving from 25x in June 2011 to 48x in June 2021. I do not think that such a doubling is likely to happen again in the coming decade.

The chart above is an updated version of our analysis from my September 2020 quarterly letter and shows our estimate of the performance drivers of the MSCI world growth and value indices in the last 10 years. This makes clear the impact that earnings-multiple expansion has had on the performance of “growth” stocks.

Taking less risk

Taking less risk is most easily achieved by holding more cash or other short-dated “safe” investments. If asset prices fall, then you can swoop in and buy at prices lower than today, locking in a higher return. If asset prices do not fall then, you will clearly have forgone the returns that holding “riskier” assets would have provided.

I suspect that some investors will proceed on a “do nothing” basis, expecting that they can quickly switch to a “take less risk” strategy as and when they think asset prices are falling. This strategy sounds appealing but is hard to achieve as major turning points in markets are rarely well signposted.

Taking more risk

Taking more risk is most easily understood in fixed income markets, where the interest rate you earn is set according to the perceived risk of the borrower not meeting their payment obligations. Orthodox theory in financial markets builds on this to say that more generally the rate of return you earn is dictated by the risk you are willing to take.

One clear mechanism for the risk/return trade off in equity markets is that when a company increases its leverage via borrowings it increases the upside for shareholders, but also the probability of them being “wiped out” if there is a bump in the road.

Doing something “clever”

What most investors would ideally like, is to find a way of side-stepping the orthodox relationship between risk and returns, to make a higher return without a corresponding increase in risk. The financial services industry is always keen to meet this desire and so there is never any shortage of products making such claims.

Given that there is no unique way to define risk it is often the case that doing something “clever” will result in swapping one risk for another. For example, the private equity industry touts the prospect of higher returns than public equity markets, but it comes with the risks of lower liquidity and higher leverage.

I am front of the scepticism queue when it comes to “clever” financial products. However, I believe that owning “high quality value” stocks is currently presenting investors with an opportunity to earn higher future returns with less risk.

I see evidence of this from a “top-down” perspective because as shown above “value” stocks have not experienced the earnings-multiple expansion of “growth” stocks, and so I see them at less risk of a corresponding multiples contraction. More importantly I continue to see evidence from a “bottom-up” view, where our research leads us to companies that we judge as high quality, having longevity of earnings power and being available to purchase at a more reasonable price than many more popularly owned companies.

Put differently, I believe that in the current market environment there is still merit to being selective about which companies you own. Whilst, equity prices are high on average, I believe that their increase relative to underlying earnings has been concentrated far more in some corners of the markets than others. Relative to many other “clever” investment products on offer, I find the argument for a “value” strategy to be reassuringly straightforward.

Investing in a low return world.

The above reasoning leads to my mental model for investing in a low return world, that I set out in the 2-by-2 matrix below.

I have mapped the four possible actions for investors to two simple questions about their outlook. The strength of an investor’s convictions in the above two questions should dictate their behaviour. Very few investors, myself included, will hold convictions so strong that they pursue only one of these four options to the exclusion of the others.

At Havelock, we have relatively low conviction that asset prices will remain permanently high and a low but not at-all-costs tolerance of low returns. This means that our approach should be skewed towards the top-left part of this matrix if we hope to achieve our goals.

The cornerstone of our approach is to hold assets that we think are reasonably priced and do not require too much optimism about the future. This requires us to understand and value each business we invest in, and I put this in the “doing something clever” category. We do assume general equity market risk and allow ourselves to hold some cash “dry powder”, so there are also elements of “do nothing” and “take less risk” in our approach. More specifically we attempt to limit the losses we will make during a large fall in general equity markets to be less than most broad market indices.

Why am I telling you all this? I believe successful investors find ways of reducing the complexity of markets to allow logical reasoning about where they think they are and where they want to be. There is no unique way to do this, but I thought I would lay out my stall for how I think about the challenges of investing in a low return world.