Taking the market's temperature

‘Investing, when it looks the easiest, is at its hardest. When just about everyone heavily invested is doing well, it is hard for others to resist jumping in. But a market relentlessly rising in the face of challenging fundamentals – recession in Europe and Japan, slowdown in China, fiscal stalemate and high unemployment in the US – is the riskiest environment of all.’ Seth Klarman.

‘It’s not supposed to be easy. Anyone who finds it easy is stupid.’ Charlie Munger.

You should be celebrating the recent performance of your portfolio after five years of anxiety, provided you sidestepped the resources and mining services sectors of course. But, as value investors, we know that bull markets and high valuations sow the seeds for poor future returns, so instead of celebrating the highs we focus on protecting what we’ve got and wait patiently for better opportunities.

Shelby Davis, one of the greatest value investors you’ve probably never heard of, who turned $50,000 into a $900m fortune over 47 years, said ‘you make your money during bear markets, you just don’t know it at the time’.

In my experience the inverse is also true. We make our biggest mistakes in bull markets, but we don’t know it until the market turns ugly. So with the All Ordinaries Accumulation Index up 111% since the lows in March 2009 (see Chart 1), let’s take the market’s pulse using Howard Marks’ ‘Poor Man’s Guide To Market Assessment’ discussed in his book The Most Important Thing, to see what action we should be taking.

Poor Man’s Guide To Market Assessment

(1) Economy: Vibrant/Sluggish

Australia’s economy is tipped to grow slightly below average over the next few years, but we’ve ticked ‘Vibrant’ as the economy is performing relatively well even though it may not feel like it. China is still growing strongly thanks to renewed stimulus, official unemployment isn’t far off record lows and low interest rates are reducing debt repayments. New car sales recently reached a record high and new home sales have just hit a two-year high.

That’s not to say all is well, though. Why else would you need a record low official interest rate of 2.5% when unemployment is so low?

(2) Outlook: Positive/Negative

We’ll turn this one over to Bill Smead of US funds manager Smead Capital Management, ‘In the latest week (October 21-25), individual investors, as measured by the American Association of Individual Investors (AAII), and investment newsletter writers, as measured by Investor’s Intelligence, were bullish by nearly a 3-1 ratio to bearish.

‘There have been very few insider buys among the companies which fit our eight criteria. Insider selling has been large and consistent recently, especially among the kinds of titillating companies which the stock market participants clamor for. Currently, the short-term temperature based on sentiment looks high.’

(3) Lenders: Eager/Reticent

In March last year interest rate comparison website RateCity warned that nearly 70 per cent of lenders were accepting mortgage deposits as low as 5%. The competition has only heated up since then with Macquarie teaming up with Yellow Brick Road to take on the banks. We’re squarely in the Eager category.

(4) Capital: Loose/tight – see (3).

(5) Terms: Easy/Restrictive – see (3).

(6) Interest Rates: Low/High

As you can see in Chart 2, interest rates are currently at record lows, which is usually not a good sign for shareholder returns.

(7) Spreads: Narrow/Wide

Junk bond yields have fallen to record lows below just 5% (see Chart 3). While defaults are very low, there’s no margin of safety if bankruptcies or interest rates increase.

(8) Investors: Optimistic/Pessimistic; Sanguine/Distressed; Eager to buy/Uninterested in buying – see (2).

(9) Asset Owners: Happy to hold/Rushing for the exits

Not only are passive owners happy to hold, but the IPO market has sprung to life as private equity groups and entrepreneurs take advantage of investors prepared to back companies with short histories, leveraged balance sheets and few competitive advantages.

(10) Sellers: Few/Many – see (9).

(11) Markets: Crowded/Starved for attention

Many individual investors have shunned the market since the GFC, with 38% of Australians owning shares. Of those, 34% are direct investors, down from a peak of 44% in 2004. Things could be changing, though. Perpetual recently recorded its first inflows for a while, and investors fed up with low interest rates may be jumping back in to the sharemarket to avoid missing out on further gains.

We picked ‘Crowded’ chiefly because institutional investors are increasing their weightings to stocks. Locally we’ve heard that small-cap managers are winning mandates, which is a sure sign of bullishness. This was recently noted by Smead: ‘We’ve observed institutions and asset-allocators burying small-cap managers with money and flooding new small-cap strategies with capital. As we read industry publications which list institutional requests for proposal (RFPs), the number of small-cap equity manager RFPs have dwarfed large-cap requests over the last four years and has not changed recently. It is no coincidence that small-cap indexes have soundly outperformed large-cap indexes over the last 14 years. Not much heat on large-cap, but plenty on small-cap.’

(12) Funds: Hard to gain entry/Open to anyone

I chose ‘Hard to gain entry’ as hedge fund manager’s Seth Klarman and Dan Loeb are returning funds to their clients due to a lack of attractive investing opportunities. I’d weight their actions over just about anyone else’s given their remarkable track records with large sums of money.

(13) Recent Performance: Strong/Weak

The All Ordinaries Accumulation Index is up 36.4% over the past two years.

(14) Asset Prices: High/Low

From art to stocks, asset prices across the board are being inflated by low interest rates.

(15) Prospective Returns: Low/High

In an article that was republished around the US with the headlines ‘Market valuations are obscene’ and ‘The stockmarket will probably crash’, US fund manager John Hussman recently calculated that ‘virtually every reliable measure of market valuation we observe is now within the highest 1% of historical observations prior to the late-1990’s bubble. “Reliable” in this context refers to valuation measures that are well-correlated with actual subsequent market returns. These measures include price/revenue, price/book, various cyclically-adjusted price/earnings multiples, and market capitalisation/GDP, among others.’

In Australia, Perpetual reportedly calculated that the price-to-book ratios of the big four banks has breached levels from the tech boom and prior to the GFC.

(16) Risk: High/Low

Marks recounted earlier in the year that the list of risks has never been so long in his career.

(17) Popular Qualities: Aggressiveness/Caution and discipline

I picked aggressiveness, as margin loans have been increasing despite remaining well below pre-GFC levels. With the amount of money currently flowing into property, many individual investors scarred by the GFC may also end up swapping one bubble for another.

More importantly, though, institutions have been taking larger and larger risks as interest rates have fallen, particularly in the fixed income markets. This could be another bubble waiting to pop one day.

Roadmap

Marks provides a three-pronged strategy for dealing with markets:

1. Stay alert for occasions when a market has reached an extreme;
2. Adjust your behaviour in response; and
3. Most importantly, refuse to fall into line with the herd behaviour that renders so many investors dead wrong at tops and bottoms.

Only history will reveal whether the stockmarket is at or near an extreme top, but our signposts suggest that we’re at least close. So what should we be doing now?

‘For your performance to diverge from the norm’ advises Marks, ‘your expectations – and thus your portfolio – have to diverge from the norm, and you have to be more right than the consensus.’

First and foremost, that means we need to avoid highly valued, popular stocks. The best margin of safety is a cheap valuation, and right now just about every high quality, high dividend paying stock is achieving record highs with regard to price and valuation.

Our minimal bank exposure in the model portfolios puts us at odds with most investors, but our (increasingly less) contrarian view on China means avoiding anything highly leveraged to the Australian economy. Even if we’re wrong, we’re confident we can continue beating the market over the long term without owning large amounts of highly leveraged banks, though we empathise with the difficulties investors that live off their portfolio are having finding safe income opportunities. Unfortunately low interest rates are the price savers are paying for Australia's high consumer debt levels.

Second, don’t loosen your discipline and invest in poor quality stocks that you wouldn’t have considered before interest rates fell to record lows. That said, don’t be afraid to invest in cheap stocks even if they’re not world beating companies. Caltex is a good example of an ugly duckling that should look more like a swan in a few years, as its retail fuel business grows. Profits and cash flow should also become more predictable once the Kurnell refinery is shut down.

Third, control your portfolio limits. Don’t put your wealth at risk by letting particular stocks or sectors constitute more than an intelligent weighting in your portfolio.

Fourth, don’t get sucked in to chasing stocks as they climb, and let valuation and a decent margin of safety temper any greedy thoughts. The time to be aggressive was in 2009 and 2011, now’s the time to ensure you hang on to your profits.

Fifth, don’t be afraid to build your cash holdings. Billionaire investor David Tepper recently told a graduate alumni class that even in a world of derivatives and complex securities cash remains the best hedge against uncertainty. His fund is currently 40% in cash, which has never been the case before, and there are plenty of other respected value investors with 30-40% cash holdings and returning capital to clients.

Sixth, consider taking advantage of the high Australian dollar to invest overseas. As well as opening up a wider range of opportunities, this will reduce your dependence on the local economy and, by extension, Chinese growth.

Last but not least, maintain your focus on value. There are still opportunities, but they may not be in the areas you normally expect to find them. Caltex and M2 Communications are two examples of stocks that haven't been chased up on a tide of popularity, but which still offer defensive characteristics and attractive valuations.

The subtlety of greed

Warren Buffett said: ‘An investor needs to do very few things right as long as he avoids big mistakes.’ The biggest mistake you can make right now is not related to analysing and valuing businesses, but rather getting greedy.

It’s tempting to ride our winners all the way without regard for valuations, thinking that we’ll be clever enough to pick the top and get out in time. Sometimes we’ll buy quality stocks at any price, knowing full well that even great businesses can produce losses if we pay too much.

The last thing most of us want to do is sell a stock only to see it keep on rising on momentum rather than a realistic analysis of its prospects. Unfortunately that’s part and parcel of value investing but, as fund manager Erik Metanomski recently reminded me, 'even when I have been quite early with such calls in the past, short term profits that I may have foregone have been dwarfed by massive amounts saved when the [proverbial] has ultimately hit the fan'. By preparing to take advantage of other investors’ greed and mistakes you’ll be well placed to beat the index for years to come.

Note: Smead also believes the ‘globally synchronised trade’ is still overcooked. We discussed this in The well known fact, as it has particular relevance to Australian investors.

More excerpts from Klarman’s last annual letter to Baupost clients

Most U.S. investors today have a clear opinion about what everyone else has no choice but to do. Which is to say, with bonds yielding next to nothing, the only way investors have a chance of earning a return is to buy stocks. Everyone knows this, and is counting on it to remain the case. While economist David Rosenberg at Gluskin Sheff believes government actions could be directly or indirectly responsible for as many as 500 points in the S&P 500, or 30% of its current valuation, traders have confidence in Ben Bemanke because betting that his policies will drive equities higher has been a profitable wager. Bernanke, likewise, is undoubtedly pleased with these speculators for abetting his goal of asset price inflation, though we all know that he will not call them first when he decides to reverse direction on QE. Then, the rush for the exits will be madness, as today' s "clarity" will have dissolved, leaving only great uncertainty and probably significant losses.

Investing, when it looks the easiest, is at its hardest. When just about everyone heavily invested is doing well, it is hard for others to resist jumping in. But a market relentlessly rising in the face of challenging fundamentals – recession in Europe and Japan, slowdown in China, fiscal stalemate and high unemployment in the US – is the riskiest environment of all.

[O]nly a small number of investors maintain the fortitude and client confidence to pursue long-term investment success even at the price of short-term underperformance. Most investors feel the hefty weight of short-term performance expectations, forcing them to take up marginal or highly speculative investments that we shun. When markets are rising, such investments may perform well, which means that our unwavering patience and discipline sometimes impairs our results and makes us appear overly cautious. The payoff from a risk-averse, long-term orientation is – just that – long term. It is measurable only over the span of many years, over one or more market cycles.

Our willingness to invest amidst failing markets is the best way we know to build positions at great prices, but this strategy, too, can cause short-term underperformance. Buying as prices are falling can look stupid until sellers are exhausted and buyers who held back cannot effectively deploy capital except at much higher prices. Our resolve in holding cash balances – sometimes very large ones – absent compelling opportunity is another potential performance drag.

But we know that in a world in which being anti-fragile is good, what doesn’t kill you can make you stronger. Short-term underperformance doesn’t trouble us; indeed, because it is the price that must sometimes be paid for longer-term outperformance, it doesn’t even enter into our list of concerns. Patience and discipline can make you look foolishly out of touch until they make you look prudent and even prescient. Holding significant, low or even zero-yielding cash can seem ridiculous until you are one of the few with buying power amidst a sudden downdraft. Avoiding leverage may seem overly conservative until it becomes the only sane course. Concentrating your portfolio in the most compelling opportunities and avoiding over diversification for its own sake may sometimes lead to short-term underperformance, but eventually it pays off in outperformance.