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In the picture II – How might we illustrate the idea of risk in value-oriented equity investing?

In In the Picture I, we jumped quickly off the springboard of the chocolate-box wisdom of Forrest Gump’s mother to consider investment risk. More specifically, we were thinking about how we might pictorially represent risk in value-oriented equity investing and were planning to build on the following chart from The most important thing by Oaktree Capital chairman Howard Marks.

25/11/2015

Andrew Evans

Andrew Evans

Fund Manager, Equity Value

In In the Picture I, we jumped quickly off the springboard of the chocolate-box wisdom of Forrest Gump’s mother to consider investment risk. More specifically, we were thinking about how we might pictorially represent risk in value-oriented equity investing and were planning to build on the following chart from The most important thing by Oaktree Capital chairman Howard Marks.

 

 Source: Schroders - For illustrative purposes only

As we explained, the chart suggests investors can expect an increasingly more uncertain range of outcomes as they move up the risk scale. We also argued, however, that an additional and important consideration is that, the longer the time for which equities are held, the more their returns should gravitate towards the average – in other words, the more the distribution curve will be condensed.

Let’s now try and work that argument into a chart by thinking about a classic cyclical company as it moves through its various phases. As economic prospects improve, for example, demand picks up, profitability rises, people become less risk-averse, it becomes easier to borrow, new competitors enter the market and both they and the existing players expand their capacity.

Eventually, however, a point arrives where there is too much capacity, supply outstrips demand, confidence falls, as does pricing and then profitability, lending is harder to find and capacity contracts. But then, of course, demand improves to a point where it outstrips supply and the whole cycle begins again. To prove a picture is worth at least two paragraphs then, all that can be summed up as follows: 

 

Source: Schroders – For illustrative purposes only

But we also need to take into account the behavioural aspect of investing – that is, the psychological biases humans experience at different point in the above cycle as they move from, say, excitement about a company’s prospect to euphoria and then on through denial, fear, despair, capitulation, disinterest, acceptance and back to excitement again. Plotting that onto the above chart, we reach:

 

Source: Schroders – For illustrative purposes only

What we are showing is that, at both the top and the bottom of the market, there is a lack of appreciation of the likelihood that profits will eventually return to more normal levels. Indeed, the reality of how the market thinks about this may be even more dramatic so, in this next chart, we have altered the distributions to show how we believe the market really acts at the top and bottom of cycles.

 

 Source: Schroders – For illustrative purposes only

To put it another way, at the top of the cycle the wider market tends to behave as if the good times are going to last forever while, at the bottom of the cycle, the other side of the mental coin sees the wider market acting as if they will never see anything approaching good times ever again. But, of course, the mean-reverting pull of the cycle means both reactions are far too extreme.

Here on The Value Perspective then, we aim to steer a steadier course – neither growing too depressed when markets are falling nor too excited when they are on the rise. By investing with a longer time horizon in undervalued companies, we are giving the forces of mean reversion a greater chance to drag prices back up to the average – just as they will drag the prices of overvalued businesses back down.

As you can see below, our own Time/Profits chart is thus subtly different from the previous two – with our longer time horizon allowing us to see the cycle merely as points on the distribution curve around average profitability. Investing in businesses at the point of despair, when the wider market sees no chance of recovery means we are helping to push the odds in our favour.

 

Source: Schroders – For illustrative purposes only

That is because we have the forces of mean reversion on our side working towards a better outcome – after investing at lower valuations, which should help lead to superior long-term returns. The risks we are taking on therefore move away from a concern about share prices moving up and down too much and towards two other risk considerations.

The first is the possibility – albeit an unlikely one – that, for whatever reason, a business or an industry has stopped being cyclical and is now in structural decline, which does not happen nearly as often as people believe. The second is that a company is hampered by too much debt, say, or too onerous a set of covenants so that it is unable to push on from the bottom of the cycle and tap into the upturn.

Even so, here on The Value Perspective, we believe that by stacking the probabilities in our favour by investing in lowly-valued businesses with strong balance sheets we stand a good chance of capturing those benefits of mean reversion over time. After all, as Mrs Gump might have told her son if ever the subject came up: “Risk is like an elevator – it is not the ups and downs you have to worry about but everything crashing to the ground.”

Author

Andrew Evans

Andrew Evans

Fund Manager, Equity Value

I joined Schroders in 2015 as a member of the Value Investment team. Prior to joining Schroders I was responsible for the UK research process at Threadneedle. I began my investment career in 2001 at Dresdner Kleinwort as a Pan-European transport analyst. 

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