As the share market continued its relentless climb in early 2018, with minimal volatility, value investing was relegated to history as an anachronism from a simpler and more innocent time. Observing fund manager peers generating high double digit returns from companies whose prices weren’t even in the same universe as our valuations, I began to question the relevance of value investing myself.
Value versus momentum
However, a conversation with one peer cemented my loyalty to value investing, despite its inferior recent performance compared with momentum and growth styles. I asked my friend why he purchased a certain company given its high price. He said that my ‘problem’ was “too much focus on value and too little focus on business momentum". Apparently, it was fine picking a business with strong sales or subscriber momentum in the knowledge that as the growth continued and the story spread, other investors would join the party at higher prices and a profit could be realised.
He had made a substantial return buying stocks this way, but my next question revealed a flaw. I asked: “If you are buying well above a conservative estimate of value, how do you know when to exit?” His answer left me uncomfortable: “That’s a good question, you’ll see it ‘rolling over’.”
He meant that when the price momentum starts to slow, the price will gently 'roll over' and that would be his sell signal. If only the market were always so kind. Prices can drop sharply without warning.
Within a week, the Dow Jones Index lost 4% in a single day and at one stage was down 10%. The financial media produced some of the most breathless headlines seen in years. Many of my friend’s stocks fell as much as 16% in a few days. I wondered whether those falls constituted a ‘rolling over’ by his definition.
Jumping aboard the fads
How can a value investor win when there is nothing cheap enough to buy? The value investor holds funds in the safety of cash and watches as prices rise inexorably higher. When the optimists are winning, as they have been recently, value investing can’t hope to beat buying the ‘concepts’ that are going up the fastest.
It’s easier to join the party and buy the latest theme, fad or concept, partly because commentary surrounding the companies usually supports the rises with what appears to be entirely valid theses.
In recent months, and reminiscent of the dotcom boom, we have seen companies simply change their name or strategic focus towards blockchain, and the market has rewarded incumbent shareholders with 300% plus gains.
For example, on 21 December 2017, the Hicksville, New York-based Long Island Iced Tea company announced a “Corporate focus shift towards opportunities strategic to blockchain technologies.” The loss-making company’s shares rallied from just under US$3 to over US$15 during the day of the announcement. At their peak, the shares were trading 411% higher than their lows only a week or two earlier.
On 9 January 2018, Kodak jumped on the buzzword and launched its own cryptocurrency, KodakCoins, which are tokens for use in the blockchain-powered KodakOne photography rights management platform. Within days, Kodak’s shares were trading 390% higher.
Then eCigarette company Vapetek changed its name to Nodechain and said it would ‘explore’ Bitcoin, Ethereum, and other cryptocurrencies. The thinly traded shares jumped 360%.
These name or business changes are reminiscent of the adoption of those ending with ‘.com’ during the tech boom of 1999 and early 2000. Back then, investors mistakenly believed that new technology - technology that admittedly changed the world - would render all companies involved profitable. It is a common mistake.
Australia is far from immune from this irrational exuberance. Perfectly valid arguments are being proffered for companies with revenues of barely $1 million and market capitalisations of $1 billion.
High likelihood of poor future returns
There is no question the US market is expensive. The CAPE ratio sits at 33 times the 10-year cyclically-adjusted earnings for the S&P500. I know the CAPE ratio includes the negative earnings of the December quarter 2008, but a simple calculation that grows this year’s earnings by as much as 10% and drops out the 2008 number reveals the CAPE ratio is still at 30 times. It is higher than at any time since the 1800’s with the exception of the tech boom.
Robert Shiller himself warns that the CAPE ratio does a relatively poor job of predicting corrections, but it does an excellent job of predicting future returns. The aphorism ‘the higher the price you pay, the lower your return’ sits well with Shiller’s findings. With the CAPE ratio at record highs, we could see future returns at unappealing low single digits for many years.
What about volatility? The S&P500’s Sharpe Ratio (generally, a measure of risk-adjusted returns) is at near-record highs and at a level history shows has never been sustained. Even if the overvaluation doesn’t lead to a correction, volatility is likely to pick up. And if heightened volatility is a risk, and prospective returns are in the low single digits, the returns offered by cash offer a superior risk-adjusted alternative.
For Australian investors, while the domestic market might not seem as expensive as US indices, you can be sure of a high correlation if the US market turns down.
Timing is uncertain
I do not know with any useful accuracy when the US market will turn down more meaningfully than it did last week, but we do know some things:
- There is little absolute value available in the Australian market for quality companies.
- Irrational exuberance has emerged in some pockets of the market.
- Ultra-low volatility and ultra-high returns (the S&P500 rose almost 20% in just the six months to December 2017) are not a combination that lasts very long.
- Market corrections are usually preceded by the types of ‘shots-across-the-bow’ that we have just witnessed.
- On a risk-adjusted basis, there may be more attractive alternatives to being fully-invested in equities.
- History allows the recent weakness to be completely reversed and then replaced by another wildly bullish rally that sees caution thrown to the wind again and irrational exuberance itself making headlines.
On balance, caution is more appropriate than it has been at any time since 2009. Howard Marks, founder of the $100 billion Oaktree Capital, recently told clients to stay "defensive or cautious". Robert Shiller has warned "People should be cautious now." Both investors also said its not appropriate to be out of the market altogether. Our own process has arrived at a rising cash weighting but we’re still 70-75% invested. So, you could say we agree.
But we’ll leave momentum investing to those who believe they can pick the top.
Roger Montgomery is Chairman and Chief Investment Officer at Montgomery Investment Management. This article is general information and does not consider the circumstances of any individual.