Weekly Talking Point - 5 November 2018

Jonathan Ramsay
Jonathan Ramsay
InvestSense Director
US Equities, Go You Good Thing... As the nation grinds to halt for the Melbourne Cup we reflect on the the surprising extent to which investors can sometimes be less rational than punters. Is now one of those times?


      1. Finance professionals have a reputation for being hard-headed numbers people (ok, men, unfortunately). Punters are generally seen to be the emotionally driven preys of bookmakers. This is far from obvious though when you look at the collective long-term track record of professional investors and even the entire market itself.
      2. You might even say that punting behaviour can look more rational than investing much of the time. As an investor you can exploit this and hopefully our Dashboard gives an insight into how you and your clients might go about it.
      3. The market is a big place, however, with emotions running high much of the time. Enough to test the patience of the most resilient and well informed. Nevertheless, individuals do potentially have an edge in their investing time-horizon (institutions, even pension funds have a famously short-term focus). We can give advisors access to the same information and navigate it’s nuances. It’s really not magic and not all that inaccessible once you peel back the first few layers although the nuances can be a bigger deal. And the final piece of the investing jigsaw, temperament, we can all work on.

    The US market will probably be the most successful over the next ten years - so why are we not putting everything on the favourite? In short, because that’s what everyone else in the market is already betting on. In the office sweepstake you may have paid a dollar to bet on a random horse and if you drew Yucatan or Magic Circle in the Cup you probably felt like you were already ahead. All thing being equal, drawing a short priced horse means you stand a higher than average chance of winning having paid the same dollar as everyone else. In the serious world of punting we know that life is not so easy as the odds reflect the probability of winning and you have to pay up for the privilege of being ‘on’ the favourite. Many investors make the intuitive but costly mistake of thinking the market is like a sweepstake. In markets betting on the favourite comes with extra risks that you don’t have to deal with in the betting ring.

    Take the Dot Com Boom. By the beginning of 2000 technology stocks were the shortest price favourites to produce the best returns for the next decade. Within months though investors suffered a a 75% loss of capital which they didn’t recover for some 15 years. For many that was a permanent loss of capital as, thinking they were on the favourite, they were disillusioned and dis-invested well before the recovery. The chart on the right shows price/earnings ratios in black. You would expect a high growth sector like Information Technology to have a higher P/E (or shorter odds) but the difference was quite extreme. This points to one difference with betting markets - we get paid by the amount the investment wins by not just for the fact that it grows more than other investments. This can lead to bouts of euphoria and unrealistic expectations. The red and green bars show the performance over the next 7 years and clearly technology stocks were not able to justify the odds. This points to another difference with financial markets and betting - no matter how much money you put on a horse it is not going to run any faster or slower. With investments a lot of money can make them run faster. A huge amount of money can blow-up the whole sector as money pours into less productive uses.

    When Backing The Donkey In The Race Makes Sense

    That often gives the underdogs a better chance of performing. The chart on the left shows the performance of the Consumer Staples sector (2nd longest odds back in 2000 in the chart above). These include relatively defensive, boring stocks like Colgate Palmolive, Campbell’s Soup or supermarkets like Coles and Woollies. Obviously they did relatively well when the Dot Bubble popped. Even more interesting though is the fact that boring old Staples really went to the races after the GFC, when high ‘quality’, defensive cash flows were most highly sought after by investors. Why would a financial crisis suddenly spark 10-15% per annum share price growth over 7 years in a sector that will always struggle to grow earnings by more than the economy, or, say, 4-6% per annum?

    What Does A Fast Horse Look Like In The Investing World?

    So far we have implicitly assumed that growth in earnings means ‘fast’. The chart on the left shows that from 2003 Tech stocks really did grow earnings faster than Consumer Staples stocks but it was almost 15 years before markets decided that was something that they wanted to pay for. In the meantime dividends became a priority for investors, so much so that eventually sleepy old Consumer Staples were eventually labelled ‘expensive defensives’.

    Investors Versus Punters - Who Are The Real Gamblers?

    Once the Dot Com euphoria had subsided tech stocks traded on much more reasonable multiples of earnings, but still a little above that of Consumer Staples. You would expect that as they are after all the faster horse. Then after the GFC things got a little strange again in this 2 horse race  Consumer Staples started to trade at higher multiples (shorter odds) than Tech stocks. During that time (2010-15) Consumer Staples stocks far outstripped Tech stocks in terms of share price performance if not earnings (see above). With hindsight this again didn't make much sense, even though for 5 long years investors in Consumer Staples stocks felt they had the real edge in markets. More recently of course financial gravity has reasserted itself and Tech stocks have roared ahead again, helped not only by strong earnings but a return of some kind of equilibrium whereby they trade at a slightly higher multiple than that of Consumer Staples.   

    So How Do You Weigh The Odds In Your Favour?

    Clearly investors preferences can change over time and, looked at through a long-term lens those shifts can be seem quite capricious. Everyone loves Winx but there is a limit to how much money people will throw away in the betting ring to prove it. So there is always some kind of value in a bet on Winx that reflects the likelihood of her winning. In financial markets however we have an observable tendency to bid good ideas up to impossible odds. This is why we have constructed a valuation methodology that aims to look through the vagaries of investor behaviour (value vs growth vs dividend vs quality preferences) over long periods. Currently we think that the starting price for Emerging Market equities looks a lot more attractive than of the well fancied US.


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