PSG Angle: Why investing in stocks, makes sense!
During rough market fluctuations such as we have experienced over the last few months, one cannot blame investors for asking the question, why should we invest in stocks? From a professional money managers perspective, the manner in which we answer this question, often illuminates critical characteristics about our investment mindsets, it talks to ones management approach and reveals personality traits.
Our view is that severe negative price moves that position already well priced companies into deep value situations are investors’ best friend, but only if your investment horizon is adequately long. This does not imply that from a psychological perspective, watching assets re-price downwards is not painful and it is difficult to negate irrelevant hysteria and focus on underlying facts and hence valuations during these times. One of the most damaging consequences of investment noise, is poor investor behaviour; we find that many clients feel compelled to take control during periods of extreme price change – most often diverging from their long-term financial plan and incurring threatening effects to their financial best interests.
‘Noise’ within our industry appears in many forms, one in particular is the daily or weekly release of ranking tables. We call this ranking-table-disease. Financial services is, in our view, the only industry we know of that publishes a manager’s performance daily and in a public medium. Management in any other industry tends to be assessed bi-annually and in extreme cases, quarterly. Even in these situations, corporate strategy dictates that managerial performance should be measured over years, if not decades. We have already mentioned above that investors reacting to changing rankings do not assist their own cause in doing so. But it is not simply the investors that suffer from ranking table orientation, most professional managers live in fear of slipping down the ranking ladder and unfortunately, this can lead to bad behaviour such as attempting to predict market movements rather than investing on the basis of underlying company fundamentals. The focus turns to mapping markets rather than understanding companies.
Long term investors that have been around the block know that buying a business at an average (fair) valuation level allows for a total return from the stock equal to the rate at which a business grows its profit, plus the dividend yield you receive on an annual basis. Although alchemy is spewed by investment professionals, if the truth be told, there really is not much more to investing in the stock market than this basic approach! A company’s growth rate is determined by the return that a company can generate on the assets in the business; research and intuition or experience play a meaningful role in establishing what growth rates are likely from a company!
Very often companies go through cyclical downturns as a result of industry specific circumstances or generally depressed economic conditions as was the case in 1998, 2003 and 2008. Correctly interpreting the investment landscape as recoverable and buying businesses at these very low valuation levels is the ultimate prize for investors. In such circumstances, the total return from the stock will be boosted by the rerating that will take place if economic conditions improve or normalize together with the conventional return additions of future profits and dividends. It is for exactly this reason, that unless companies are already on a red-hanger sale, having some cash available is a wise strategic approach to money management. The converse of companies re-rating from low P/E levels during market panics is when businesses are grossly overvalued but optimism is high. Buying stocks on cyclical upturns and high ratings often results in real losses as future dividend and profit flows are eroded by the de-rating in the stock price as economic conditions become more depressed, which is typical in cycles. Probably the most extreme example of this is the period from 1969 to now, where the capital return from stocks, when adjusted for inflation, has only been half of the growth in profits over the same period.
We feel that given time, market pricing will be no different to what we have seen in previous decades. Whilst many quality companies we would want to be invested in on the JSE are far from cheap, the same cannot be said in other parts of the World, particularly developed markets and most notably in Europe. However, in time, we believe opportunities will emerge on the JSE too! We eagerly await our chance when great quality companies with long-term track records of delivering profits to shareholders are once again out of favour on our market and are priced at bargain levels – this will probably occur as when we enter an economic downswing, particularly a consumer downswing. As is customary at these times, it will psychologically be the most uncomfortable time to buy shares and our persuasive powers will need to be at their most heightened levels to persuade our clients to follow our advice. In a nutshell, building long term wealth through stock investments, involves taking risk as stock prices fall, this at a time when investment appetite is collapsing and deep-seated fear rising!
The attached graph is from a recent report by Niels C. Jensen, from Absolute Return Partners. It shows the Shiller P/E* for the German and French stock market and is trading at the same level during the 2008 credit crisis and levels back in 1982.
Many people are fretting about the high probability of another recession in Europe and the US and would therefore look at the above graph with a great deal of scepticism. We would argue that in Europe’s case, stock prices of many companies’ are already reflecting such an outcome, or worse.
Consequently, we think there are European companies that from current price levels will be offering investors sound returns over the next five to ten years.
Enjoy your week!
*Also, known as the cyclically adjusted P/E. The Shiller P/E smooths the impact from economic cycles. It calculates the P/E as a 10 year average and adjusts for inflation.