‘Let me conclude with one of my favorite clichés – the French saying: ‘The more it changes the more it’s the same thing.’ I have always thought this motto applied to the stock market better than anywhere else. Now the really important part of this proverb is the phrase ‘the more it changes.’ The economic world has changed radically and it’ll change even more. Most people think now that the essential nature of the stock market has been undergoing a corresponding change. But if my cliché is sound – and a cliché’s only excuse, I suppose, is that it is sound – then the stock market will continue to be essentially what it always was in the past – a place where a big bull market is inevitably followed by a big bear market. In other words, a place where today’s free lunches are paid for doubly tomorrow. In the light of experience, I think the present level of the stock market is an extremely dangerous one.’
Benjamin Graham, 1974
‘Markets continue to behave as they always have, swinging pendulum-like between the depths of despair and irrational exuberance.’
‘Insanity: doing the same thing over and over again and expecting different results.’
The United States, which makes up just shy of 50% of the MSCI All Countries World Index (ACWI), is still by far the biggest chunk of the global market. This market, along with many other developed markets, is looking distinctly pricey at the aggregate level. A recent article in the Wall Street Journal showed that irrespective of the valuation metric used, the US market is at higher levels now than it was at the peak of most prior markets (Chart 1).
Chart 1: Percentage of Prior Bull-Market Peaks With Lower Valuations Than Current Market
Source: Wall Street Journal
Many other world markets have exhibited similar meteoric price rises since the bottom of the market during the financial crisis, thanks in large part to the heavy-handed fiscal and monetary stimulus on the part of the authorities – which achieved what was intended, driving investors back into riskier asset classes such as equities. And so we find ourselves, as we did in 2007, standing on a somewhat precarious ledge looking back at more than five years of remarkable returns from the global market, and wondering how solid the ground is beneath us. In the case of the current bull market, the returns have been an astronomical 17% above inflation per annum since the market’s lows in 2009 – remembering that the global market has delivered a rather more sanguine 5% per annum real return since 1900. (Credit Suisse 2013)
Unfortunately patting ourselves on the backs or berating ourselves for missed opportunities is seldom helpful in deciding how to invest for the future. Ascertaining where we are now, however, is a worthwhile pursuit in understanding how to position portfolios for prospective returns. As a starting point it may be instructive to take a step back in time to the peak of 2007 to look at the similarities and differences to the current market. From there we can attempt to work towards the implications for structuring portfolios.
There are risks and opportunities in the market regardless of where it is trading
While it’s interesting to observe the whole market at the aggregate level, this doesn’t assist you in ascertaining where to allocate capital. That is, unless you’re an advocate for passive investing – a view that naturally tends to be particularly prevalent at the height of a bull market, when overall markets have run strongly and many active managers have struggled to keep up.
As active managers, it’s no surprise that indexation makes no sense to us. We agree with David Green, portfolio manager of deep value firm Hotchkis & Wiley who explains: ‘In the indexation process, there is no attempt at price discovery. The only thing that matters is the relative size of the asset: the bigger the market capitalization, the more an investor should own. This means if the price of a large asset goes up more than the market as a whole, indexers have to buy even more of it. In a true capitalist system, the rule is the higher the price, the lower the demand. With indexation, the higher the price, the higher the demand. This is insane.’
In delving beneath the market’s surface, it becomes apparent that in any environment there are always risks to be avoided (assets trading well above what they’re worth) and opportunities to be taken advantage of (assets trading significantly below what they’re worth). This is true regardless of what the ‘aggregate’ market valuation is telling you and even when markets appear to be tending towards extremes.
A Tale of Two Sectors
In 2007, the financial crisis took the entire investing population by surprise. There was heightened risk hidden in the financial system, caused by the shadow banking system and all the resultant nefarious tricks and traps in the securitised products that came along with it. This risk was unanticipated by growth and value investors alike and most were stung by exposure to the financial sector when the bubble burst. The story of what happened in the financial sector – and how – is well-documented and firmly filed in the annals under ‘What Not To Do Next Time’.
Chart 2: World Basic Materials and World Consumer Services Price-to-Book Values (to October 2007)
Source: Thomson Reuters Datastream
The story that’s less well-told is that of resources – specifically the heady heights these stocks rose to on the fiction of the never-ending Chinese Super Cycle Commodity boom before the collapse of the market. Chart 2 shows that the price-to-book ratio (P/B) of the World Basic Materials Index reached more than two standard deviations above its long term mean in October 2007 when the market peaked.
Conversely, other sectors in the world index were trading at P/Bs significantly below their long-term mean and looked like they might represent opportunity. However, these weren’t the shiny, happy companies riding the wave of the Chinese growth story – these were somewhat more boring businesses in sectors such as consumer goods and services, healthcare. These sectors had no explicit link to the Chinese powerhouse and looked decidedly uninteresting as a result. The market loves a good story and it’ll search high and low for evidence to confirm what it wants to believe – that beloved stocks will continue to rise forever, and continue to deliver prosperity. Which of course they do. Until they don’t.
Markets today are a mirror image of 2007
Fast forward to today. Crudely assessing the markets on the same basis, are we seeing a repeat of 2007? One could argue that current markets look very much like 2007 in that segments of the market appear to be very cheap and segments appear very expensive. However, these segments are almost the mirror image of what we saw in 2007. Today, after the rude and sudden turning of the global cycle, it’s resources stocks that have lost their lustre. As Chart 3 shows, the same consumer-oriented companies that were overlooked in 2007 for their dull stable qualities, are now highly sought after for the very same characteristics.
Chart 3: World Basic Materials and World Consumer Services Price-to-Book Values (to August 2014)
Source: Thomson Reuters Datastream
A bottom-up approach sometimes reveals interesting top-down patterns
At RECM, we’re bottom-up value investors. Occasionally, information or bad news pertaining to whole sectors or countries will narrow down the hunting grounds for singular investment ideas. We like to “fish where the fish are” and often whole parts of the markets will become cheap for a common reason. But our research and analysis is painstaking, and done on a case-by-case basis with every security researched and evaluated in its entirety. We have no ‘top down’ investment process that allocates chunks of capital to asset classes or sectors. Sometimes, in following this process, we notice with interest that a particular sector or theme may percolate to the surface, however.
Table 1: RECM Global Fund Top 10 Holdings – October 2007 and August 2014
Table 1 compares our top 10 holdings in the RECM Global Fund at the peak of the prior market (October 2007) to today (August 2014). It shows that in 2007, before the market capitulated, we held many consumer-oriented businesses and no resources stocks. Today however, the converse is true – most of the securities in our top 10 are resources businesses and the household consumer names we held in 2007 no longer feature.
It may not look like it at face value, but while the sectors and stocks are different, our strategy is in actual fact the same today as it was in 2007. We’re invested in those businesses that are cheap and thus represent our best odds of investment success – considerable upside prospects with limited downside risk – and we’ve again steered clear of businesses that are trading above their worth and thus represent poor odds.
Resources stocks fell just as hard as financials in 2008
Contrary to the popular opinion at the giddy heights of the market in 2007, resource stocks didn’t go on to prosper ad infinitum from the voracious appetite of the Chinese to consume all commodities the world would ever produce. The precipitous fall of financial stocks during the market collapse in 2007 is well-known. Less well-known is the fact that resource stocks fell as hard as financials, dropping 63% from peak to trough with many individual stocks falling by considerably more than this.
Since then, the focus has switched from shiny things to reliable things. The demand is now for those businesses deemed to be high quality, with more stable earnings, reliably paying dividends – for which the market is prepared to pay seemingly any price. Quality businesses do generate brilliant investment returns when they’re priced to do so, but don’t when they’re not. A good example of a time when they were “not” was the Nifty 50 bubble in the 1970s. The Nifty 50 was a group of companies so appealing that their stocks should always be bought and never sold, regardless of price. Among these were companies like Johnson & Johnson, Avon, Coca-Cola, Disney, McDonald’s, Polaroid and Xerox. Each was a leader in its field with a strong balance sheet, high profit rates, and double-digit growth rates. From their 1972–1973 highs to their 1974 lows, the Nifty Fifty fell spectacularly from grace with stocks like Xerox down 71%, Avon 86%, and Polaroid 91%.
Quality shouldn’t trump price
We agree with James Montier of GMO who states ‘The golden rule of investing: no asset is so good that you should invest irrespective of the price paid.’ He substantiates this well by comparing the returns of quality businesses when they’re cheap to when they’re expensive (Chart 4), with predictable results.
Chart 4: Returns of Quality Businesses vs the S&P 500
Chart 5: Current RECM Resources Holdings
As it turns out, following the very same strategy we followed in 2007 has resulted in very different holdings today – and many of these, while heroes at the previous market peak, are pariahs of today: resource stocks.
RECM’s analysis uses incentive pricing for resources stocks
Something else that’s remained the same throughout is the manner in which we value securities. We continue to use a rational and repeatable methodology that doesn’t rely on crystal ball or navel gazing, but employs sensible assumptions and inputs. Relevant to resources, it may be useful to illustrate how we come up with commodity prices for use in our models – since these could potentially introduce significant forecast risk into our investment theses.
The good news is that we’ve taken heed of all the evidence that shows forecasting commodity prices – much like forecasting anything else – is a fool’s game and impossible to do accurately and consistently. Instead, we prefer to use what we term the ‘incentive price’ of a commodity in our models. This is the price that incentivises producers to supply as much of a commodity as the market requires. The price should be sufficient to allow the marginal producer – the producer at the higher end of the cost curve – to cover their operating costs and earn enough profit to meet its cost of capital. This equilibrium price is typically taken to be the price at which the 90th percentile producer on the cost curve is making an economic return. Chart 6 shows the aluminium cost curve and incentive price.
Chart 6: Aluminium Cost Curve
Source: Morgan Stanley
Through observing cycles of various commodities over time, the 90th percentile appears to represent the tipping point. If the price rises above this level, even the highest cost producers are incentivised to bring production on line, with lower cost producers also producing at full tilt. This inevitably leads to excess supply relative to demand, with resultant downward pressure on the price. If the price of the commodity drops below the incentive price, higher cost producers are no longer able to meet their cost of capital. This either voluntarily or involuntarily reduces production and even the lower cost producers shut down their higher cost facilities. This causes a drop in supply, which when it falls below demand, places upward pressure on the commodity price. The price moves back towards the incentive price and the cycle continues.
Incentive prices allow analysis to look through the cycle
Today many commodities are trading at prices below their incentive prices, reflecting that they’re at low points in the capital cycle. This makes sense given the drop in demand as a result of the global recession and the build-up of inventory for most commodities that occurred at the peak of the cycle.
By focusing on a ‘normalised’ or fair price for the commodity, we’re able to calculate intrinsic value for businesses looking through the cycle, rather than focusing only on today’s circumstances as the market seems to prefer to do. This enables us to buy businesses that are temporarily at low prices. This strategy has proven to be a winning formula for investment success over time, if you’re more right than wrong about these potential mispricings.
Meticulous research is a powerful analgesic
This approach to investing may seem sensible, but there’s a nasty short-term by-product that comes along with it – you have to endure short-term price volatility and often temporary losses. This is made even more difficult by the fact that it isn’t easy to prove that losses are temporary before they’re recovered! Unfortunately, while market timing is something we’d love to master, we know better than to bother trying. It’s simply not possible to get it right consistently.
But we know that if we do our research in such a manner that it gives us a high degree of conviction in how much a business is worth, we’ll probably be able to sit through the discomfort of short-term price movements, and even build our position further if prices decline. We know that the significant long-term gains that market inefficiencies dangle as carrots are only available to those investors able to endure the stick on the other side.
The aluminium and platinum group metal cycles are at similar points. Both commodity prices are showing some upward movement as a result of the supply and demand pressures detailed earlier. But despite the evidence that both cycles are playing out, aluminium share prices partially reflect the good news while platinum share prices remain stubbornly low. Unfortunately it simply isn’t possible to know when market prices will reflect reality except to say a mispricing exists that will at some point be corrected. We continuously review our thesis to ensure we aren’t missing a piece of the puzzle, but our conviction in our thesis thus far remains intact.
Oil and energy also present compelling opportunities
Another theme that floats to the surface when looking at our current portfolio is the presence of a number of oil and energy stocks. Our thesis on this sector has been well documented (‘Frack on! Investing in US Natural Gas’ REVIEW Volume 27, April 2014 and ‘Striking Oil’ REVIEW 16, April 2011), but it’s worth pointing out again that market myopia – the inability or unwillingness of market participants to look beyond current circumstances – has again presented opportunities.
In the case of Ultra Petroleum, a natural gas producer we have exposure to, the market seems to be assuming that natural gas production will continue climbing on an ever-steepening trajectory thus keeping natural gas prices at all-time lows relative to oil. But with the price having dropped so significantly as fracking sent production into overdrive, the number of gas rigs in operation has already fallen to less than half that of 2007 while the substitution effect has seen many consumers switching to natural gas over oil consumption. Natural gas prices are set to normalise as the steep fall in gas production plays out and demand continues to climb. And so the capital cycle continues.
We can accurately predict that the cycle will turn, but we cannot predict the timing or extent of the turn. Luckily, just knowing that it will turn is enough for an investor to position themselves for investment success – as long as their investment time horizon, and clients’ continued trust allows for this to play out.
In summary, markets aren’t dissimilar today compared to 2007. They continue to behave as they always have and always will with the pendulum swinging continuously from exuberance to despair and back again. Stocks that are flavour of the day have risen well beyond their worth and those that are out of favour represent great value for the diligent and patient investor. Einstein said that insanity was doing the same thing over and over again and expecting different results. Despite the fact that at times our contrarian stance may cast credibility on our mental health, there is method in our madness. We do the same thing over and over again and hope for the same results. If you employ a consistent process of unlocking this value and avoiding the risks, the result will be the same no matter how different the underlying opportunity sets are – real growth in capital with significant protection against downside risk. The trick is to have a process that’s disciplined, consistent and thus repeatable.
Forbes. “The Nifty Fifty Revisited,” December 15, 1977, 72-73.
Montier, J. “No Silver Bullets in Investing (Just Old Snake Oil in New Bottles” December 2013.