How predictable is the future
Daniel Kahneman’s excellent book, ‘Thinking Fast and Slow’, is a double edged sword for anyone in the investment industry. Kahneman does little for the ego of fund managers who believe they possess some rare combination of skill and intuition which allows them to deliver consistently superior results. However, if one can get past the slight stumbling block of engaging in a profession without a discernible value proposition, Kahneman offers great insight into the way in which we make decisions and the anchoring and biases which impact them. Understanding these biases in our behaviour is critical to bridging the gap between the economists’ nirvana where all individuals behave rationally and every asset is the risk adjusted value of its future cashflows and the somewhat less theoretical reality in which confidence in the future elevates with improving conditions and rising prices and plummets as prices and conditions abate. Whether and how there is scope to profit from this confluence of theory and reality depends significantly on whether you believe there is any predictability in the future.
Kahneman’s scepticism on the ability for investment professionals to deliver sustainable results (other than through pure luck) is based on the lack of predictability inherent in the environment. He highlights two basic conditions for acquiring a skill: “an environment that is sufficiently regular to be predictable; an opportunity to learn these regularities through prolonged practice”. One would need to be an incorrigible optimist to claim predictability in any economic or stock market variables in the short term. Anyone hoping for the holy grail of smooth, superior to market returns is likely to be sorely disappointed (Bernie Madoff comes to mind). This does not prevent an army of analysts back testing every imaginable data set to reveal patterns providing the raw material for another investment product launch. We may be similarly deluded, but our belief is that whilst wholly unpredictable in the short term, variables such as revenue and earnings of companies and the path of economies become more predictable by reverting to longer term time frames and that a disciplined approach to investing with reference to these long term cycles can deliver value. Whether we like it or not, this view rests significantly on one of the themes which Kahneman explores, being regression to the mean. Much of our investment process is aimed at trying to avoid the pitfalls of an environment in which noise and emotion result in constant re-evaluation of the value of businesses based on the most recent data points (extrapolating unusually strong or weak outcomes into perpetuity).
Those of us believing in long term regression to the mean have found elements of the recent market environment challenging. As we have consistently bemoaned, central bankers, politicians and regulators have been assiduously aiming to prevent the process through ever lower interest rates, quantitative easing and further inducements to borrow and bring forward more growth from the future. Widening income inequality is an obvious outcome of stymying natural cycles; it is not natural for interest rates, house prices, stock prices, commodity prices or most other variables to head in only one direction. Consistent reinforcement of this irrational expectation has led the majority to anchor their expectations on exactly this occurrence. Frustration at the individual stock level has emanated from the resulting tendency of investors to price anti mean regression. Nearly all of the strongest performing stocks over the past year are characterised by the coincidence of exceptionally high current multiples with earnings and return on capital levels that appear unsustainably high. Rather than pricing regression to the mean in these returns, investors are pricing ever widening gaps between winners and losers. REA, Navitas, Seek, Ramsay Health Care, CSL, Carsales, and James Hardie are amongst these winners. In addition to commanding multiples well above market averages, all of these businesses are earnings, margins and returns well above average. One or two, such as James Hardie, have been very long term portfolio holdings and are extremely well run businesses which we hold in the highest regard. This does not mean that we believe they are great investments at any price. Suffice to say, we will not be choosing the present time to relax our belief in the tendency to revert to the mean.
On the stock specific front, the impending removal of Fox Entertainment from the S&P/ASX200 index will largely sever the ties between Australian investors and the Murdoch controlled company. Having used dominantly Australian capital to fund the creation and expansion of his global media empire, it is frustrating that Mr Murdoch has seen fit to extinguish the Australian listing of the company to save costs that equate to several months of his annual salary. Those of us still recovering from his successful engineering of the 2004 vote which saw obsequious shareholders solve his tax problems and facilitate the change in domicile of the company from Australia to Delaware to enshrine weaker governance principles, cannot help feeling a little bitter and twisted. A Board of Directors which has facilitated these moves, the appointment of his sons to some of the most senior positions in the company suggests the efforts of investors to improve corporate governance and the protection of minority shareholders still have some way to run. The Board undoubtedly carried out a thorough global executive search for the positions, or at least a global search of those with the surname ‘Murdoch’.
Signs that rising asset prices and more freely available debt are typically correlating with heightening corporate activity (and a total ignorance of all the anchoring and biases highlighted by Kahneman) were plentiful during April. Transurban paid more than $7bn for a portfolio of roads from Queensland motorways, South Africa’s Woolworths paid $4.00 a share for David Jones while private equity and other vendors prepared yet more repackaged offcuts for sale.
On the other side of the equation, significant downgrades for the likes of Coca-Cola Amatil (-16.1%) suggest the forces on earnings can still work in both directions.
Hindsight will undoubtedly render prospective movements in stocks wholly predictable to the great majority. History suggests cycles which should be relatively predictable through observation of the long term are usually less obvious in prospect. This is particularly the case when cycles have been long in duration, offering far greater opportunity to anchor expectations in the recent past. The current downswing in the commodities cycle which has resulted in lower commodity prices, sharply declining capex and decimated stock prices across the commodity spectrum was apparently predicted by the majority of pundits. The fact that stock prices rose to ludicrous valuations, that the terms of trade boom was totally squandered by the government and that CEO’s within the sector were almost universally optimistic on Chinese and Indian demand negating traditional cyclical forces, suggests it may have been less obvious at the time. House prices, building approvals, interest rates, credit growth and indebtedness in general along with a host of other variables are at various points in their observed ranges through time (most are nowhere near average levels). Some of these variables are well understood by investors to have cyclical patterns through time. Others, such as house prices and credit, have patterns which are more difficult to interpret. Whilst the short term vicissitudes of these cycles will always be difficult to predict, we will always be more comfortable investing where there is recognition of the existence of cycles, as investors face the greatest risk when variables which are cyclical (almost everything) are considered to have uninterrupted structural growth.
For this reason we remain very comfortable with investments in many commodity related businesses. Concerns over China are widespread (and valid), the cycle in commodity prices is well known and dimensioned with reference to cost structures (when prices fall low enough some producers go broke), the harsh reality of downturn has curtailed capacity addition and valuations are not excessive. Businesses linked to asset price valuations (banks, insurers, asset managers, property trusts and developers) offer us far lower degrees of comfort given their underlying earnings drivers are generally well above normal levels and progressive intervention and regulation has desensitized investors to these cycles. These views are long term, and by definition, cannot guarantee any modicum of short term investment success. Bernie Madoff is not one of our role models.
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