At the height of the dotcom bubble in 2000, money was pouring into the tech sector pushing up prices as investors expected stellar increases in profits and growth to continue. At the other end of the spectrum were tobacco companies. Unloved by the market, hampered by litigation battles, and in structural decline in their traditional markets, company valuations floundered.
10 years later, if you had invested £1000 in British American tobacco you had £6080. If you had invested in amazon, you would have only £2000. You might think this is because the profit growth assumptions made by investors were wrong. They were in fact proven to be correct: the profits at amazon grew faster than British American tobacco. The key difference was the starting valuation of each stock. When it comes to equity returns, what you buy is important but what you pay is paramount.
As value investors, we focus on understanding risks so that we can weigh them against potential rewards. For long-term investors, there are only two types of risk: the risk of a permanent loss of capital; and the risk that you do not make an adequate return on your money. But you cannot consider risk without reward, and of course vice versa. We ask ourselves at what price would we be compensated for the risks?
Unfortunately, most people are driven by emotion when it comes to their perception of risk and reward. Many commentators refer to the 2000s as the ‘lost decade’ for UK equities. It included the dotcom - crash of 2001 and the credit crunch of 2007, and this has left an understandable scar on the psyche of investors. It means that in recent years, many have attempted to build portfolios to shield clients from the short-term swings that we have seen. This has led to areas of the market that are seen as ‘safe’ trading at elevated valuation levels. Today it is defensive stocks – including the likes of British American tobacco – which are very expensive whilst cyclical sectors are being ignored.
We would argue that there is no such thing as an asset class, or indeed any asset, that is always safe or one that is always risky – your risk is determined by the price you pay. In the search for safety and profit stability, investors are making the classic mistake of avoiding profit risk, but accepting elevated valuation risk – a risk that history suggests is ultimately more painful.
The seeds of any prolonged upswing are sown in the recession that takes place beforehand. It is the crushing of sentiment and valuation that occurs during those ‘uncertain’ periods that creates the conditions for significant share price increases over time. At present, despite significant improvements in corporate health, many attractive companies continue to trade at low valuations. We cannot forecast exactly when the market will recognise the intrinsic value of the companies in which we are invested, but by placing emphasis on strong business fundamentals and low valuations, value investors can recognise companies with considerable potential for sustainable long-term share price recoveries.