| Economic apocalypse or investment cycle? |
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| The market must return to fundamentals and reassess its approach to investing in the current climate, says Mark Daly. |
Einstein’s Theory of Relativity refined the mathematics behind the importance of a reference point when observing and measuring things; in Einstein’s case, objects moving through space and time. Relativity suggests that a stationary person looking at something going by at the speed of light will see it differently than a person travelling alongside at the speed of light. Similarly, our frame of reference can have an equally distorting effect of our investment viewpoint.
I remember sitting with an investment colleague at lunch in the later days of the dot.com bubble in early 2000, discussing whether in fact we were wrong not to accept the “new paradigm” thought leadership of investment markets of the time, which held that the old fundamental rules of company stock valuations such as PE ratios, free cashflow and even profits were irrelevant for the future. It proposed that a company’s future was more highly dependent on a potential income that will arise when everyone does everything on the internet. In other words, the growth prospects of a company were much more important when valuing a company than its demonstrable ability to produce income. | | Mark Daly |
Crucially, this ‘new paradigm’ viewpoint was becoming accepted wisdom across the globe: fund managers held this belief; governments held this belief; the man on the street held this belief. Life had apparently changed as we knew it. Forget the past. It’ll never be the same again! Prices were going up and everyone was making money. Happy days.
Years later we look back with mirth (and some measure of embarrassment) at the fallacy of it all. Tut tut, we say, obviously this was a ridiculous concept. Companies, projects and strategies that have a value do so, because they bring value in products or services to the wider population. We must therefore rely on carefully looking at what they bring to the world and the price we pay for it must make sense - in essence we will make profit if we buy when these things are cheap and then sell them again when they are in demand and their price has gone up. Buy low, sell high. Right then we said to ourselves; let’s not let this happen again!
Back to the future
Autumn 2008. Armed with our knowledge of past booms and busts and our incredible self-belief in our own ability to rationalise information, where are we today? Doom and gloom. The financial market as we know could cease to exist in an instant! Start planning for financial apocalypse! Start stocking the shed with tinned beans! Life has changed as we know it. Forget the past. It’ll never be the same again!
Buy low, sell high anyone? When the long-suffering editor of the Wall Street Journal was asked why he believed market booms and busts occurred, he suggested that human nature meant that we go from periods of unbridled optimism driven by greed to periods of unbridled pessimism driven by fear and that the markets merely reflect the wider world. The former condition is dealt with famously in Robert Shiller’s book on stock market bubbles Irrational Exuberance.
So perhaps, just for one moment, let’s assume that the world is not about to end and that people and companies will continue, more or less, to go about their business. Let’s assume also that, in general, governments and regulators will do their best to restart inter-bank lending and curtail inappropriate lending practices. Let’s also assume that, after a period of retrenching, that our human nature to better ourselves and get ahead will mean that some day soon we will begin to look kindly on companies, projects and strategies that earn us money. Then maybe we could perhaps look at the world today from a different reference point one that could potentially offer, dare I say it, one of the best opportunities to buy low and sell high in quite some time. Will we look back in 2-3 years and think how simple a decision it should have been to begin investing again? Will we look back with mirth (and some measure of embarrassment) at the fallacy of our thoughts of financial apocalypse?
The investment phrase of the summer was, and still is to a large extent, “Don’t catch a falling knife”. Even now, we are unsure when the world’s unbridled pessimism will turn a corner and begin to improve. At this stage of a cycle everything looks grim. The motorway of capitalism - consumption to commerce to profit to asset price growth to wealth effect is now being pummelled with every new dawn and each new financial and economic analysis. There is no light at the end of the tunnel. In fact it is well documented that the initial turn to the better happens in the darkness of economic despondency and market capitulation.
Yet optimism is difficult just now. As house prices fall in Ireland, the US, Britain, Spain and elsewhere consumers do not feel confident enough about the future and so they retrench. It may be as simple as a car upgrade that gets put off, but the multiplicative effects of cancelled discretionary purchases is an aggregate reduction in commerce. This begins to affect the value of all things from investment projects, to companies, to stock prices. As demand dwindles, there is no upward pressure on prices. We start seeing special offers and business preparing to accept lower profit margins. This downward spiral continues apace until such time as households begin to feel enough financial comfort from their modest savings that they begin to spend and invest again. This looks some time away just yet. And yet it is exactly at times like this, just when things look like they can’t get much worse, that asset prices are at their most lowly valued. By the time consumers begin thinking about going back out shopping it is likely that asset prices will already have priced in a re-emerging optimism. Where is the point when consumers turn the corner from discretionary spending to discretionary saving?
There are tentative signs of this already. Analysts are reducing their inflation estimates. In fact they now suggest that retail sector prices could fall into deflation. They argue that the US economy is already experiencing an output gap of 2 per cent-3 per cent, meaning that inflation could fall by 1 per cent in the next 12 months. Perhaps people have stopped spending and begun to save. However, it would be unwise to take this as evidence of the beginning of the end, but instead perhaps it could be a sign of the end of the beginning.
Learning from past mistakes
Let’s say that we do want to now start carefully accumulating investment assets again. Imagine we have the ability to manufacture a portfolio from scratch; what would be a sensible way to do this? Perhaps this is a good time to reconsider our past experiences here and learn from some of our mistakes. We won’t be alone. Over the next few months many of those responsible for management of money - pension trustees, boards of management, etc, will be doing exactly this: reassessing their fundamental approach to investing, their investment objectives, their real level of diversification and the assumptions that they have historically employed. The expectation is that many will adopt new strategies and employ new managers to implement their strategies.
Much of the recent poor performance of Irish investors could be levelled at three things - too much property, too much exposure to Irish equities and too much leverage. Recent research found that in general Irish investors had not enough global diversification, not enough asset class diversification and unrealistic return expectations. We took too much risk in concentrated areas, sometimes with borrowed money.
We must return to fundamentals. Investments in each asset class increase in value from one of three things: a) the market goes up and your investment rises as a result (Beta); b) the market goes up and your investment rises more than the market (Alpha); or c) the market goes down and your investment rises (Hedged Alpha). The debate will continue to rage as to whether returns are more effectively achieved by having low-cost passive exposure through something like an index fund or ETF (A-type investing), by entrusting this to a higher-cost active manager who will seek to outperform the index (B-type investing), or by a manager who can trade the asset class both ways to give the option of hedged alpha (C-type investing).
Traditionally, Irish investors do a lot of B-type investing and entrust money to managers or funds that seek to provide mostly beta (market returns) but with some element of alpha provided on top. Unfortunately, this has meant that many such investments fell as heavily as markets did in ‘07 and ‘08.
Another option to consider
What has become apparent is another option; one that has been at the forefront of thought leadership in investing for the last 20 years. It advocates a much higher proportion of a portfolio being exposed to C-type investing, where investment returns are not based solely on how the overall asset class does but on the success of a manager’s investment decisions. What the likes of the Harvard and Yale endowment funds (the so-called Super-Endowments) began in the 1980s was to allocate funds to a portfolio of C-type investments, thereby exposing them to an average of hedged alpha manager return. Not only did they do this, but they also reduced their allocation to traditional asset classes such as stocks and bonds and actively invested it the more unusual asset classes such as commodities, emerging markets and private equity. This is interesting for Irish investors to consider if we want to begin investing again but do not know exactly when the right time is. If we have beta (market) exposure and we time it incorrectly we could catch that falling knife! But if we can identify the specialists in each niche of each asset class, we could put together, bit by bit, a diversified allocation to hedged alpha across all asset classes. Would Einstein approve of this?
In this new dawn, if we set out with sensible return expectations, a portfolio approach with real diversification, a positive attitude to alternative asset classes and with the fundamental desire to buy low and sell high, we could just let compound interest grow our money. It was Albert Einstein after all that suggested, with a smile, that compound interest was the most powerful mathematical formula in the universe! |
Mark Daly, is a member of the Investec Wealth Management team
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