2013 has been a year of conflicting sets of economic information. On the one hand, low interest rates and tentative improvements in data from some developed economies have been causes for investor optimism - yet uncertainty surrounding, among other things, the Eurozone, Central bank monetary stimulus, the US federal budget and growth rates in emerging markets has been more disconcerting.
The nervous interplay of relief at signs of so-called ‘green shoots’ and unease inspired by the global economy’s failure to address its imbalances continues to make markets volatile and sensitive to short-term news flow. While recognising these kinds of political and macroeconomic issues are important, however, here on The Value Perspective, we continue to assert that investors are better off focusing on the fundamental analysis of companies with a focus on valuation and balance sheet strength.
The strong performance that has resulted from adhering to such an approach over the last five years – a period in which macroeconomic issues and debate have never been far from the headlines – is testament to the fact that valuation is ultimately a far more reliable driver of long-term investment returns than changes in GDP, employment data, earnings growth or other such considerations.
Unfortunately, while value investors will have found the strong performance of their portfolios in recent times immensely gratifying, they should also be aware that it is unlikely to continue at the same pace. The returns generated by value investing can be highly variable over shorter time periods and the lesson from history is that less rewarding times will inevitably lie ahead.
Over longer time periods, of course, value investing tends to be highly consistent in delivering strong returns. As such, accepting there will be periods of short-term weakness and, in spite of these, remaining focused on the longer term is a key tenet of successful value investing.
Another important part of a value investment philosophy is a willingness to be contrarian. To be prepared to selectively reject the current consensus view – even though it will feel a little unnerving - to reap rewards in the future.
As an illustration of this, think back to 2008 and 2009 when the consensus approach – motivated by fear and macroeconomic concerns – was to do what seemed most comfortable at the time and either not own shares at all or to invest in what many viewed as ‘reassuringly expensive’ defensive companies.
A value style, on the other hand, would have led you to avoid such stocks and – based on attractive valuations given acceptable degrees of risk – invest selectively in economically sensitive businesses, such as retailers, industrials and financials. While that may have felt unsettling, not following the consensus in this way proved to be very rewarding.
Today, however, we are increasingly facing the opposite situation. Market sentiment has swung from fear towards greed and many company valuations are increasingly unattractive – if not outright expensive.
Rather than being swayed by emotion or economic forecasts, the more objective guide of valuation now points to exiting investments that have surpassed their fair value. Furthermore, as we noted in Taboo or not taboo, if suitable new opportunities can’t be found, investors should be happy to hold more cash rather than buy stocks which compromise their valuation and risk criteria.
A perceived risk of holding more cash in times such as these it that, if markets continue to rise, an investor will miss out on the gains being enjoyed by others – and in the short term this may well be the case. In the long run, however, the risk to the absolute value of your portfolio in hard currency of owning overvalued investments is far more significant. Selling expensive shares is as central to the success of a value investment approach as the buying of cheap ones.
In these more exuberant times, it is not just the depth of a value investor’s financial analysis that is important but also their emotional fortitude. The former is of course vital in identifying whether investments are attractively or unattractively valued and in appraising the associated risks.
It is the latter, however, that instils the confidence to act on the outcomes of this work and to take decisions that are difficult or seem counterintuitive. Over a three to five-year investment time horizon, it is precisely these types of decisions that will add the most value to an investor’s portfolio.