Fortune favours the brave
As the flow of negative economic news continues unabated, stimulating optimism in battle weary equity investors is becoming increasingly difficult. The commodity boom is long forgotten, as companies scale back production, close loss-making mines and retrench personnel, while the financial sector continues to reel from adding far too much staff in the buoyant times, necessitating some significant adjustments as revenues evaporate. After one of the worst calendar years ever in the stock market, logic would suggest that 2009 should offer better news, however, January provided little fuel for the optimists as the S&P/ASX200 lost 4.9%.
Volatility does not equal risk
From our perspective, probably the most interesting aspect in current investor behaviour is the somewhat perverse definition of risk which is seemingly adopted as stocks continue to fall, perhaps stemming from the dependence and use of volatility as a definition of risk. The years of buoyant returns on all assets and aggressive use of financial leverage were accompanied by an ever declining fall in volatility. As volatility (or measures derived from it) was the primary measure of risk, this led to forecasts of a much smoother economic cycle, greater risk tolerance and increased leverage. A casual observer might (correctly in our view), conclude that risk was actually rising through this entire period on the basis that valuations were high versus historic levels and financial leverage was high and rising. Being one of mathematical rather than emotional persuasion, I’m tempted to condense this assessment into what could perhaps be termed an irrational equation of risk (High + Extremely High = Low). As we’re all now painfully aware, times have moved on. Share prices have fallen sharply, huge amounts of equity have been raised to recapitalise an over leveraged corporate sector and earnings are in the process of falling sharply as economic activity languishes. Rather than conclude that the risks inherent in purchasing stocks are reducing, as valuations fall to levels at the more pessimistic end of historic experience and financial leverage moves back to more sustainable levels, investors seem to be searching for a new irrational equation (Low + Lower = High). My hopefully rational maths would dictate that forward looking risk must now be substantially lower than 12 months ago. Volatility based risk definitions would again disagree with me, as traditional measures such as tracking error continue to rise.
A polarised market environment
Trends at the stock level can be summarised fairly succinctly at present: defensive. Top sectors in January included healthcare (+6.1%) and telecommunications (+0.1%). Worst performers included industrials (-11.1%), property (-9.7%) and consumer discretionary (-8.8%). Safety continues to be sought in stocks expected to weather the economic storm. Financial leverage continues to be as popular as George Bush at an inauguration ceremony and earnings risk is a spectre which all investors acknowledge as a fait accompli, yet run from regardless. Stock evaluation at present seems to be following a fairly syllogistic pattern. If the earnings of a business are likely to fall, the stock price will fall, therefore one should not purchase any stocks with the risk of falling earnings. As stocks expected to experience weakening earnings are rather more numerous than those with positive impetus, the turnstiles are crowded at the gates of the popular. The result is an increasingly polarised market environment, in which valuations of those with earnings risk and financial leverage could best be characterised as distressed and those at the other end of the spectrum are almost as effervescent as at the peak of the bull market. Given the above comments on irrational equations, it is a fair assumption that this is not the area in which we find great opportunity. Just as we were not believers in perpetually strong growth, we are not believers in perpetual recession. I will stick my neck out and claim that with a high degree of certainty, there will be an economic recovery! In predicting the length and severity of a downturn, I will offer no such guarantees, but every downturn (even the Great Depression), has been followed by an upturn.
The trends towards defensives and away from risk only accelerated further in January. In no way do we decry the performance of many defensives. To the contrary, we believe they are all solid well managed businesses. However, in looking at the actual risk involved in an investment, investors must be cognisant of both valuation, and the fact that not all high quality businesses have a stable earnings profile. Swapping earnings risk for valuation risk is not an indefinitely successful strategy, as the point will necessarily be reached where the (perhaps) lower risks in their cashflows, are more than offset by the fact that these cashflows are priced at 2 to 3 times the multiples for riskier ones. Added to the prospect that the earnings trajectory for cyclically challenged businesses may not be perpetually negative, we believe investors must be willing to look across the chasm and buy businesses based on what they earn in an average year, rather than next year. In most cases, investors have shown little willingness to embrace this strategy. Surprisingly, BHP Billiton has proven an exception. Despite the fastest fall in commodity prices ever seen, and severe share price falls for most other commodity players (regardless of gearing), the attraction in BHP Billiton’s lack of debt, has overridden earnings concerns. Its size, together with ongoing concerns on many other large Australian businesses, including banks, have seen it emerge as the paradoxical deep cyclical safe haven. We struggle to embrace this logic.
Despite most organisations adapting quickly to changing market conditions, it is hard to let the month pass without commenting on Merrill Lynch’s struggle to come to terms with times of greater adversity. As UBS and others take aggressive steps to ensure employees share the pain of shareholders, I suspect John Thain will be rightly vilified for some time to come for pursuing an alternative course. Bringing forward bonus payments and keeping them at levels more reflective of superior profitability is not the sort of behaviour we would see as reasonable for companies in which shareholders have suffered severe losses. Don’t get me wrong, as a staunch capitalist, I’m all for individuals delivering value being rewarded for this value, I just have difficulty equating a multi-billion dollar loss as a circumstance which would justify multi-billion dollar bonuses. Bank of America shareholders and U.S. taxpayers seem to have more than adequate reason to be peeved. Good things normally eventuate from times of adversity, and hopefully insisting on executives using a slightly better directed moral compass, will be one of them.
Be greedy when others are fearful
Comments above should make it abundantly clear that we believe we are moving into a period in which significant opportunity is available for those willing to embrace risk sensibly, as others become increasingly fearful. Amongst the plethora of oft used advice from Mr Buffett, the suggestion that investors should be greedy when others are fearful and fearful when others are greedy, resonates loudly at present. We have been surprised at how quickly fear has consumed investors, and whilst predicting the nadir of this sentiment will border on impossible, we are confident that we are well past the optimal time for being fearful.
In the Australian market, we believe there is good reason to move forward with a greater degree of optimism. The 2008 calendar year was one in which the equity market digested around $40bn in capital issuance, at a time when almost no new money was flowing into equities. Using the bath analogy, plenty of water was draining out the plughole as companies had no choice but to seek new equity to repair balance sheets. The taps filling the bath were switched firmly to off, as deteriorating conditions saw investors flock towards cash. Whilst we would expect the capital raising task to have some time to run, in all likelihood, we are past the peak, and the disconcerting sucking sound should abate as the plug is returned. As cash offers increasingly dismal returns, particularly in a jurisdiction like Australia, which insists on taxing it at rates which make saving even more unattractive, some water is likely to eventually make its way back into the bath. With the plug back in and the taps back on, you don’t need to be a physics guru to suggest that the level may start to rise. Additionally, tentative signs that credit markets are beginning to function again, will hopefully ease the currently intense pressure on companies from bankers belatedly tightening credit standards and hoarding capital.
Stocks now offer attractive prospects
In looking for stocks which are likely to benefit from this (currently opaque) optimistic vision, we would suggest that businesses which have been savaged by financing concerns (including banks) together with those which have been at the centre of investor panic on earnings are most likely to spur a recovery. I for one, would find a recovery led by defensive businesses trading at multiples barely below all time highs, surprising indeed. We are certain not to be successful in the timing element, however, we are adamant that investors should not approach the equity market with a strategy of not losing money, rather than making it, indefinitely. Stocks offer far more attractive prospective returns now than they did 12 months ago, and risk needs to be assessed on a forward looking basis. Large numbers of high quality, sustainable businesses are available at attractive valuations, and investors do not need to assume the risks of buying poor quality businesses in adopting a more positive stance. Economic data and newspaper headlines will be gloomy for some time to come, however, forward looking investment returns are not usually best when sentiment is ebullient.
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