Commentary

With summer fast approaching, it rekindles memories of perusing the wine list on holiday and being confronted with many unfamiliar names, producers, and grape varieties, with the occasional familiar ‘brand’.  The latter is often accompanied by a price-tag several multiples higher than the cost of buying the same bottle at home, and we are left with a quandary.  Are we prepared to pay more for familiarity, and if so, how much?  Or do we trust the experience and recommendation of an expert (in this case, a sommelier), in the hope of enjoying a superior wine, at a much more reasonable price?

We have written previously that, after a decade of delivering incredible returns, the US (which remains 68% of the MSCI World Index*), ‘growth’ as an investment style, and the 10 largest companies, all dominate many investment portfolios.  However, the first 4 months of 2022 have shown that perhaps some of the price premium paid for familiarity by ‘price insensitive’ buyers (typically retail investors or passive index trackers), hasn’t resulted in the enjoyable experience they were hoping for.  Now that the share prices of some of these companies have fallen, there may be an opportunity to buy them for less of a premium, but what about trying something new, which could also be high-quality, but less familiar?

Just as with labelling all wine simply ‘red’ or ‘white’, labelling over 40,000 listed securities as either ‘growth’ or ‘value’ is overly simplistic.  As part of our ‘quality value’ approach to investing, we look to identify companies that have a long track-record of operating success, conservative balance sheets and that appear attractively priced.  Every candidate investment is evaluated against a quality ‘scorecard’, which features 14 different factors, using a combined quantitative and qualitative approach.  This is very different from many traditional deep-value funds that tend to use only simple valuation metrics to identify opportunities, and perhaps pay less attention to the quality of what they are buying. 

As a boutique asset manager, our company may be less familiar to you than some of the industry heavyweights.  It’s also likely that there are company names in our fund’s top 10 holdings which will be less familiar too.  By thinking outside the (wine) box, you may just uncover a boutique, with a rigorous and disciplined investment processes, which invests in quality companies without necessarily paying a ‘familiarity premium’.

*Source: MSCI

As an active investment manager, we put ourselves forward as being able to deliver better than average performance for our clients. This is a tall order. To believe it is possible requires either hubris or a belief that we have an edge over other investors.

Setting out to manage other people’s money based on excessive self-confidence alone is not a great plan. Despite this, the investment industry can often encourage such behaviour. In the short-term you can get lucky, whereas it takes years to demonstrate true skill. Narratives are often crafted retrospectively, which can draw both investment manager and client into a belief that everything the former touches turns to gold.

Real investors understand the importance of remaining humble.

So, what then, do I think is our edge? I see three distinct sources, one that is transient and two that are permanent.

A Value Investing Tail Wind

The “growth” style of investing has had a prolonged period of outperforming “value”, such that there are many more proponents of the former than the latter. As I have written about before, the evidence suggests that this out-performance was driven much more by the price investors are willing to pay to own a high growth company than by actual growth in earnings.

In the long run we believe that the returns from owning a company will mirror the underlying earnings from their business and I think many investors are proceeding in the belief that this is not so.

Relative to history the optimism pessimism “gap” between “growth” and “value” styles looks extreme (as measured by the price-earnings multiples of indices on the two cohorts). As a value investor I believe this means we are fishing in a pond with less future success “baked” into the share price of companies at a moment in time when there is less competition to land these catches. It is this that I think could provide us with a transient edge.

Time horizon

If you can think like a long-term investor, I believe it conveys an advantage. It is however easier said than done.

One of the companies that we are a part owner of recently experienced a bump in the road. The company shut down a new initiative, at great expense and much embarrassment, because they believed it would never deliver an acceptable return. The company’s share price fell in response to this news, as many investors decided to walk away.

A recent broker research note on the company shared their latest valuation, with a base-case of £26 per share and an optimistic-case of £33. At the time the note was written the share price was around £19. With a potential 30% upside, you would have thought the brokerage house would be tripping over themselves to recommend buying the shares. However, their outlook was “neutral” because the “path and timing of the potential value crystallization remains unclear”.

This story is typical of the unhealthy focus on the short-term that I see in markets. In the case of this company we may, or may not, be right and we certainly do not know what the catalyst for a share price increase will be. What I do believe is that attempting to “time” a purchase or sales based on second guessing what the short-term will hold leads you down a path of missed opportunity. Being a long-term investor requires patience, often in the face of discomfort, which is a virtue I do not see being widely practiced.

Ignoring the noise

We live in an age where we receive a virtual firehose of information on a 24/7 basis. This leads to the stereotype of the investment professional sat in front of banks of screens full of scrolling news and flashing numbers. As you get drawn into this world, the nuggets of information give our brains little dopamine hits and draw you into thinking they have an exaggerated importance.  

My formal training (many years ago) was in statistics. This taught me the importance of looking beyond the noise that we are confronted with in so many aspects of life. I see this skill as related to, but distinct from, being a long-term investor. All investors have limited bandwidth – which means that time is your most valuable commodity. Even a long-term investor can squander their time with distractions that are ultimately not important.

When we make an investment decision, it is based on a thesis, which sets out why we think it will be successful. In my opinion a good investment thesis normally depends on one or two “big” things, rather than many “small” ones – being able to see the “wood for the trees”. I think that the human brain is wired to be distracted by “noise”, and if you can overcome this it will help to make better investment decisions.

Alignment of interest

My savings are invested in our fund, which provides an alignment of interest with our customers that seems surprisingly rare in an industry where you are not expected to eat your own cooking. Furthermore, Neil and I are owner-operators of our business, which I think means that our decisions are less clouded by career risk than is often the case.

I believe that being a large investor in the fund, and part-owner of the management company, helps reinforce the edges that I describe above. I believe it makes me more able to focus on long term investment decisions and less distracted by short-term noise.

I do not know the extent to which these advantages will help us deliver on our goal of delivering good long term compound returns. What I hope you are reassured by is that we are not proceeding based on hubris. In the land of the blind, the one-eyed man is king!

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.