Value Perspective Quarterly Letter - 3Q 2015
Without short-term volatility, we would not be able to deliver exceptional long-term returns
130 years’ of equity market data show that, on average, the price you pay is the key determinant of whether or not you will make money with an investment. This is the crux of value investing, and the key driver behind our client portfolios’ long-term success. The quid pro quo is that we never know how long it will take for the market to recognise the value of our investments, and this means that returns can be volatile over short time periods. While volatility may adversely affect returns in the short-term, it is also the source of our long-term outperformance, as we can take advantage of share price weakness to invest in strong, yet undervalued companies.
Ensuring an adequate “margin of safety” negates the need to rely on forecasts
Nobody knows what the future will bring. This is why, in our view, it is vital to explicitly avoid taking economic views that might influence portfolio decisions. We take steps to minimise the effects of market downturns, such as we are seeing now, by ensuring all of our investments offer us a “margin of safety”. This means only investing in companies on low valuations and with the strength of balance sheet that offers them the best chance of making it through tough times. It is also why we hold a stock for, on average, five years. Even after big market falls, such as the financial crisis or dotcom bubble, markets have tended to bounce back quickly. But to benefit from the bounce, investors must be able to believe in their process enough to sit tight through the market panic. Only through a disciplined adherence to our value approach, irrespective of the prevailing market environment, can we benefit from the significant rewards that this investment style is proven to generate over the long term.
Risk should be defined as “the probability and magnitude of permanent capital loss”. To classify “risk” as volatility is a mistake – real investment risk is the chance of losing forever some or all of the money that you have invested. We work diligently to avoid permanent capital loss. This involves in-depth analysis of balance sheets and financing arrangements to ensure that the capital risks of investment are well understood. Avoiding excessive leverage, poor management, poor capital allocation, and, most importantly, high valuations, is paramount if we are to preserve and grow our clients’ capital over the long-term.
Investing in commodities
Given the recent declines in a broad range of commodities, we are increasingly being asked about our views on investing in that sector. We tend to apply the 10-year cyclically adjusted price/earnings ratio (CAPE) when valuing companies. This effectively smooths out the peaks and troughs of an economic cycle by dividing a business’s current share price by its average profits over the previous 10 years, adjusted for inflation. Over the past 18-months or so, the basic materials sector has increasingly shown up as being cheap on this basis. Until recently, however, we have remained on the sidelines as we do not believe that even 10 years of history are sufficient to assess a full economic cycle for a mining company.
Broadly speaking, the past decade has been a good one for the miners (barring a short blip in 2008-9). This insight has helped us steer clear of the miners for some time, despite many of them appearing cheap on a 10-year CAPE. Go back 20 years, however, and commodity prices were much lower than they are now – as, by extension, were mining company profits. Averaging out these two contrasting decades should therefore offer a much more realistic view of the profitability of the basic materials sector.
Source: Schroders Datastream, 2015
As can be seen, the sector currently stands on a 20-year CAPE valuation of 10x, which is very close to every other trough over the period. As value investors, what piqued our interest was that each time the sector has approached these lows before, it has gone on to deliver strong returns. The potential upside, should valuations revert towards their long-term mean of 16.2x, is therefore significant.
By focusing on 20 years of history we’ve been more conservative and realistic, and have therefore only started to get involved when the sector has started to look genuinely cheap. Of course, whilst the overall sector appears undervalued today, that doesn’t mean that every individual stock is. Each potential investment must be appraised on its individual merits.
The views and opinions displayed are those of Ian Kelly, Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams and Andrew Evans, members of the Schroder UK Specialist Value Team (the Value Perspective Team), and other independent commentators where stated. They do not necessarily represent views expressed or reflected in other Schroders' communications, strategies or funds. The Team has expressed its own views and opinions on this website and these may change.
This article is intended to be for information purposes only and it is not intended as promotional material in any respect. Reliance should not be placed on the views and information on the website when taking individual investment and/or strategic decisions. Nothing in this article should be construed as advice. The sectors/securities shown above are for illustrative purposes only and are not to be considered a recommendation to buy/sell.
Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.