Commentary

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.

During a recent Zoom meeting with a team of highly-regarded industry experts, I was asked about our approach to “top slicing” – the practice of selling down part of your original investment in a company as its share price increases. The question put to me was that if we were “top slicing” were we, in the words of Warren Buffett, “cutting the flowers and watering the weeds”? Were we taking money out of the “winners” we had identified and funnelling it towards the “losers”?

I found myself later ruminating on this question and my initial answer.

It transpires that Buffett had asked to borrow the quote from the famed money manager Peter Lynch[1]. Might I be contradicting the sage advice of, not one, but two of history’s great investors?

Locking in a profit by selling an investment that has gone up provides psychological comfort and makes an investor feel that they are “doing something”. This psychological bias can draw an investor into making bad decisions. Good investment ideas are few and far between and you need to be confident that you have a better alternative before rushing to the exit.

Buffett’s early career as a value investor had a big focus on buying “cigar butts” – part shares of weak companies that were out of favour but that could deliver “one last puff” of financial reward to those who invested in them. He has evolved as an investor to focus on buying great businesses, where their ability to successfully reinvest their profits provides patient investors with a long-term financial reward. The common thread is an analytical focus on paying less than you think an opportunity is worth, whilst the difference is in how reactive you are to market prices.

With all else being equal, we would much rather be investing in great companies for the long-term than scouring the streets for used cigar butts to puff on. However, I believe that the enthusiasm for companies with stable and rising earnings has made owning many of them less attractive at current prices. I think this risks some investors committing an alternative psychological mistake of paying a hefty premium for the perceived comfort of avoiding uncertainty.

Where does this then leave us?

There are two types of alternative opportunity that I currently see.

Firstly, I see opportunity in companies where their earnings are not smooth, but where we believe they will be reliable over the course of an entire business cycle. To again quote Buffett – “I’d much rather earn a lumpy 15% over time than a smooth 12%”. I believe that such companies are often viewed with unreasonable pessimism in the bad years, coupled with unrealistic optimism in the good ones. If we believe that such a company is subject to a bout of extreme optimism, then we will sell our investment if we see better opportunity elsewhere.

Secondly, I see opportunity in low growth companies that have long track records of returning capital back to shareholders via dividends and buybacks. Such opportunities are often associated with mundane industries and provide us with an income stream that we can invest elsewhere. Again, we will move towards the exit if we think that the share price of such a company is implying a level of growth that is ahead of a realistic view of the future.

The share price of a company can rise because its underlying business has improved or because there has been a mood change amongst investors who are rushing to own it. It is hard to untangle the two, but our approach is to attempt to do so. We regularly update our valuation of every business that we own, and for a growing business our valuation will rise over time as that growth is realised. We would be happy to be a long-term shareholder in every business that we invest in but will exit if we feel confident that there is a wide disparity between our analysis and the market consensus.

We will not always get these decisions right, but by having a strong process, we aim to avoid bad psychological habits at all costs. Ultimately, we are trying to balance the risk of selling great investments too soon against the risk of getting drawn into wishful thinking.

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[1] https://www.cnbc.com/2017/10/17/how-warren-buffett-taught-peter-lynch-the-value-of-making-mistakes.html

Have you ever found yourself standing in a field surrounded by cows? I learned that it is a situation made more stressful when accompanied by two children and a partner who does not share your philosophy of bovine encounters. Just as my wife started reading our last rites an apparition appeared, in the form of a jovial dairy farmer. He explained that the cows were curious, that we should stand our ground and that as they drew closer one of them would scare the herd into submission. Sure, enough one twitched and they all beat a hasty retreat.

This experience stuck with me as a lesson in the behaviour of crowds. The ebullient young cows egged each other on, until for no good reason they all decided to leg it.

The current euphoria in financial markets looks increasingly driven by animal spirits. The commitment of central banks to support markets seems to have removed all fear of losing money and get-rich-quick stories are being transmitted through social media, drawing in newcomers who want a share of the action. As a value investor I am sceptical of “this time it’s different” narratives. We are living through an era of extreme change, but history suggests that this is no reason for complacency.

It seems that financial markets are being increasingly dominated by price insensitive buyers. This label applies equally to the passive index investor who implicitly accepts current prices as the best guide to true value, the speculator who hopes to flip their purchase to a “greater fool” and the optimist who believes a company is so destined for success that there is no price at which it is too expensive.

Investing based on the perceived value of what you are buying requires analysis that links financial markets to the real economy. It is time consuming and offers few high-octane thrills. The growth in passive investment products is a good thing – but rests on the premise that everyone else is doing their homework to tether prices to a pragmatic view of what the future holds. In a world where prices are set on a whim it makes less sense, especially given the increased concentration of many indices into a narrow group of companies.

It is concerning that capital markets are increasingly detached from the economic activity that underpins them. Being a business owner and getting to share in its profits is a good way to build wealth and the stock market provides a convenient mechanism to democratise access to this. However, a speculative bubble will risk perpetuating the view that markets are a form of legalised gambling set up to serve the interests of those who work in them.

This brings me back to the cows.

When you study market history the end of a speculative mania rarely has a clear explanation for the herd’s retreat. The cows, it turned out, did not have much conviction in their need to get close and so it did not take much to frighten them. To this end when the current market euphoria breaks, I suspect it will be for a seemingly inexplicable reason. History suggests that the same animal spirits that lift markets will also work in reverse, with a small twitch rapidly turning into a mass exodus.

It is the corners of the market where prices appear most detached from real economic activity that present this risk – the same parts of the market that will draw in new participants hoping to get rich quick.

The desire for a comfortable retirement is an almost universal goal and the investment industry exists, in a large part, to serve this need. I am deeply sceptical that democratising leveraged derivatives speculation will prove to be a good way to help an aging workforce retire in comfort. At worse today’s euphoric markets have the potential to turn an entire generation away from responsible pension saving and I think it is in the interests of the financial services industry to make sure that this does not happen.

Perhaps this requires a shift of mindset with a redoubled focus on the true role of capital markets? At their heart they are democratic – because they allow all of us to own a slice of the real economy. Much like a farmer watching over his herd, we need to act as responsible stewards of other people’s money.

There continued to be a buoyant mood in markets in Q4 – helped by the positive clinical results, and subsequent approval, of several vaccines for COVID-19. This was despite many northern hemisphere countries facing substantial “second waves” of infections.

Following the announcement of the Pfizer vaccine trials on 9^th November many companies perceived to be most impacted by the pandemic saw large share price gains. By way of example one of our portfolio companies, Host Hotels, saw its share price increase by 30% in a single day. I believe that the link between company share prices and their underlying business conditions is often “fuzzy”, and market moves such as this only serve to reinforce this belief. Whilst the vaccine news is undoubtedly positive, for many such companies I thought the size of the reaction was disproportionate. It felt that many market participants were rushing “from one side of the boat to the other” to buy up companies that would benefit from a return to normality.

Observing markets in the last year has, more generally, served to strengthen my belief that short-term price movements are dominated by emotion more than detailed analysis. It has felt that the link between “Wall Street” and “Main Street” has become particularly stretched (not that the history books suggest they have ever moved in lockstep).

My conviction that there is a risk of an asset price bubble has strengthened over the last three months. I believe that this bubble is particularly focused in the US on companies that are perceived to be “high growth” or have dominant technology franchises.

What is the case for us witnessing a bubble?

• The total value of all public US companies relative to US GDP is “off the charts” with a ratio of 1.9x. During the “dot com bubble” this ratio peaked at 1.4x[1]. This is a metric favoured by the famed investor, Warren Buffett, and is at the highest it has been in 50 years. The extent to which this ratio has “spiked” in the last two years gives me cause for concern.

• There has been a frenzy of companies raising capital on the public markets. Much of this activity has been via “Special Purpose Acquisition Companies” (SPACs) – which are a way of raising money from investors with less scrutiny than a traditional Initial Public Offering (IPO). It is the first year in history that US companies have raised more than $100Bn in IPOs, with more companies having been made public than at any point in the last 20 years.[1]
• From a “bottom-up” vantage point the valuation of companies such as Tesla or Nikola look, to my eyes, hard to justify. The ascent in Tesla’s share price has been so rapid that it appears, to me, to have the hallmarks of a speculative mania. The company has a market share of global car sales of circa 0.7%, but it is now worth more than the combined value of its eight largest competitors[2]. For a discussion of Nikola see my last quarterly letter.
• There exists a compelling “this time it is different” story. The cornerstone of this is low interest rates and very “accommodative” monetary policy, that pushes investors to justify paying higher prices for assets in the search for yield. There appears to be an acceptance that interest rates will be low for a long time into the future, that Central Banks will support asset prices and that this can be achieved without any other adverse economic consequences.
• There appears to be a growing public euphoria for share trading. Google Trends data[3] for North America shows that google searches for “share” during 2020 have been higher than at any point since 2004 when the data begins. Bubbles are always accompanied by stories of making “easy money” that stoke up a “fear of missing out”. I believe that podcasts, YouTube channels and such like are providing the means to disseminate these stories and encourage retail speculators.
• Whilst more difficult to quantify, it appears that sentiment in the markets is not being impacted by bad news in the way that might be expected. A bad unemployment number or surge in virus cases seems to be taken as a sign that there will be more stimulus – which will be good for markets. By the opposite token good news that is positive for the economy is also taken as good for markets. I do not see how this can continue and am concerned that many investors are being lulled into a false sense of security by the “heads I win, tails you lose” environment.

What about the opposing view?

For each of my points above there is an opposing view.

• There is no fixed law governing the overall size of the US stock market relative to the general economy.
• The frenzy of IPOs could be rationalised by the continued move to a digital economy creating many new worthwhile investment opportunities.
• Companies, such as Tesla, could be argued to have such strong technological advantages that they offer sufficiently high long term future growth to justify their current valuations.
• Low interest rates could remain for many years and, despite the massive monetary expansion, may be accompanied by economic stability – for reasons that may not be obvious.
• The public enthusiasm for stock markets could turn out to be not such a big deal, or perhaps a rational consequence of more individual pension saving or even a lack of any other worthwhile investment options in their view.
• We could be at the cusp of a continued disruptive technological revolution, meaning that the prospects for the future are great irrespective of the minutiae of 2020.

I think it will be clear which side of the debate I lean towards. When I look at the evidence collectively, I believe that there is a real risk that we are seeing a bubble in some asset prices.

What are you going to do about it?

Our approach to protecting our client’s money from this threat is two-fold:

• We look to own relatively lowly-leveraged public companies, where valuations do not rely on an undue level of optimism. Our approach keeps us away from owning companies where high valuations can only be justified by forecasts of their businesses seeing high growth for a long time into the future.
• We currently hold a fraction of the fund in cash, both as a form of risk control, limiting the fund’s exposure to falling equity prices, and a source of dry powder that can be quickly deployed when risk aversion increases in markets.

It is my belief that forcing yourself to be fully invested in equities is like tying one hand behind your back when it comes to managing the risk of financial loss. It means that your risk of losing money is entirely determined by your choice of investments, without any other way to make this risk stable through time. We believe that if our risk of financial loss is consistent through time it will in turn help increase our long-term compound return.

Our investment mantra is that we wish to own a portfolio that will be robust in a range of scenarios. This is because there are many factors in financial markets that we cannot realistically expect to forecast. This balanced approach has served us well since we launched the fund, but risks making us, at times, look needlessly cautious. In the scenario that financial markets are not adequately reflecting the economic impact of the pandemic, I think this caution will be justified.

Despite my concerns of an asset price bubble, I see evidence that there are many companies that do not require optimistic forecasts to justify their current prices. Increases in market prices have not been unilateral for all companies. For this reason, I believe that a valuation focused approach to investing offers both an opportunity for profits and a way of side-stepping the most egregious speculative excess.

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[1] https://www.bakermckenzie.com/en/newsroom/2020/12/ipo-report-2020

[2] https://wolfstreet.com/2021/01/02/tesla-finally-almost-hit-500000-deliveries-2-years-behind-its-2016-promise-for-a-global-market-share-of-0-7/

[3] https://trends.google.com/trends/explore?date=all&geo=US&q=shares