Beware the two biggest threats to equity portfolios – with Dan Rasmussen
Overvaluation and bankruptcy risk have the power to destroy a portfolio, warns our latest podcast guest – and just because they have not been penalised in recent years does not mean they are no longer dangerous
Given value investors strive to focus on objective facts and data rather than subjective emotion and noise, regular visitors to The Value Perspective might be forgiven for thinking we would steer well clear of anything described as ‘meta’. Usually they would be right but since our latest podcast guest is a keen advocate of ‘meta-analysis’ in investment, we thought we should take a closer look at the idea.
“Investing is not a game of analysis but meta-analysis,” says deep value investor and author Dan Rasmussen. “What I mean by that is, it is not important what you think but what you think relative to what is priced into markets.” To make his point, he asks, if we were armed with the certain knowledge China’s annual GDP growth would dwarf the US’s over the following decades, which of the two would we have backed in 1995?
“You would say China, obviously,” Rasmussen reasons. “If you know with certainty China’s GDP will grow at 10% a year, why put money in the boring old US, which will grow at around a quarter of that? But it turned out China was massively overvalued in 1995 and the US was really cheap – and so, despite the hugely different growth outcomes, you made a lot more money from the US than China over that period.
“You always have to step back and say, for example, I may believe electric vehicles are going to become more popular than they are today but what is priced into markets? Is it that they will get a little bit more popular or a lot more popular? Might they become both massively more popular and massively more profitable? What am I betting on? What are the odds?
“So much of investment is driven by narrative and thematics – and this is often what sells because private investors tend to think analysis is sophisticated. They might conclude, yes, electric vehicles are coming – we should bet on electric vehicles. Or, we have hit peak oil and oil usage is going to decline – it makes sense never to invest in another oil stock again. What they are missing, however is that meta-analysis element.”
That, in turn, requires an element of financial analysis to assess what is priced into markets and how to think about that. “Valuation multiples – price-to-book, enterprise value-to-EBITDA or whatever you prefer – are the simplest way to do that,” says Rasmussen. “They will tell you roughly what percentage of a positive or negative narrative is already priced into a stock at the time you buy it. That is where meta-analysis comes in.”
Rasmussen readily concedes, however, that meta-analysis can also be applied to narratives or trends. “Of course, you could also say, I think the electric vehicles narrative will get more, not less, popular and I want to ride that trend – and that is a reasonable way to invest,” he points out. “There is a lot of evidence for momentum or trend-based investing so I am not averse to that. But you have to know what you are doing.
“You do not want to be the guy who has such conviction around electric vehicles that, when the market mood changes, you are still in something that trades at 500x sales when everyone else is running for the exit. That is going to be a really bad outcome for you and again shows how important it is to understand what is priced into markets before you bet on your own analysis.”
The thing is – as Rasmussen also acknowledges – meta-analysis, like value, has had a bad run since the global financial crisis. “Let's be honest, what has worked up until March of 2020 has been analysis, not meta-analysis,” he notes. “It has been find whatever the hot thing is and bet on it – basically go long tech and, the bigger and more ‘momo-growth’ the tech company, the better, right? That has just been the winning strategy.
“One of my friends calls it ‘the dentist portfolio’ – what does your dentist own? Well, he owns Facebook, Amazon, Netflix and Google and he throws in a little bitcoin and ether because he heard about that from his buddy. And the sad thing is, that portfolio has just crushed all of us professional investors, right? The dentist is looking like a genius for now.”
Scylla and Charybdis
That “for now” is crucial, though, as Rasmussen is adamant investors must not forget what he colourfully terms “the Scylla and Charybdis of markets”. “The two great threats to your equity portfolio are overvaluation risk and bankruptcy risk, both of which can have the same kind of impact on the stocks you own,” he explains. “And just because you haven’t seen one or other be penalised doesn’t mean it is not a risk.
“The long sweep of market history tells us overvaluation is a very big threat – arguably it is the biggest threat to your long-term returns, right? That you just paid too much, prices went down and you lost money – that is the oldest story in the book. And yet, over the past five or 10 years, overvaluation has been rewarded. The more overvaluation risk – and it is risk – that you took, the more money you made.
“So what does that drive people to do? They take even more esoteric overvaluation risks. They buy dogecoin instead of bitcoin. They buy Chinese venture capital instead of US venture capital. They trade off – taking higher prices while accepting less revenue, fewer profits and less visibility. That may have worked in recent years but it doesn’t mean it is riskless. It is a big and ever-increasing risk to long-term portfolio success.”
It is a similar story with bankruptcy risk, argues Rasmussen. “Lots of people are worried about moral hazard,” he points out. “They are asking, if we keep lowering rates and deferring the default cycle, are we rewarding risk-taking in leverage? Again, for now, that hasn’t been punished but it does not mean it is not a very serious risk. Just because you have been getting away with it doesn’t mean you can stop taking it into account.”
Associate Investment Director, Equity Value
I joined Schroders in 2016 after spending 3 years as an analyst at the Royal Bank of Scotland. I them moved in to the Value team in January 2018 as an investment specialist after working for two years in Schroders' Distribution division. I am a CFA Charterholder and hold an MSc in Corporate Strategy from The University of Nottingham.
Juan Torres Rodriguez
Fund Manager, Equity Value
I joined Schroders in January 2017 as a member of the Global Value Investment team and manage Emerging Market Value. Prior to joining Schroders I worked for the Global Emerging Markets value and income funds at Pictet Asset Management with responsibility over different sectors, among those Consumer, Telecoms and Utilities. Before joining Pictet, I was a member of the Customs Solution Group at HOLT Credit Suisse.
The views and opinions displayed are those of Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans, Simon Adler, Juan Torres Rodriguez, Liam Nunn, Vera German and Roberta Barr, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated.
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