Value Perspective Quarterly Letter - 2Q 2015
The aims behind low or negative interest rates and the other elements of central banks’ quantitative easing (QE) programmes are well-known. The hope is they will encourage people to save less and spend more, to reduce the cost of corporate debt, to spur growth, to create a “wealth effect” and so on. But with the world’s central banks all doing the same thing, could their efforts to improve the economy unintentionally create distortions and increase risks in the market?
Many investors have become used to policymakers stepping in to calm markets whenever volatility has risen, and this has indeed led to increased confidence. There was evidence of this in a variety of areas in the second quarter, with merger and acquisition activity pushing higher in the US, sell-side analysts becoming more bullish on stocks, and higher loan-to-value ratios for UK commercial property deals. Indicators such as these have been strongly correlated with stockmarket levels in the past, with the suspicion being that both investors and company management teams become more inclined to put capital to work when sentiment is good, rather than when valuations are cheap.
Back in March 2009, the Bank of England initiated its QE programme in order to save the economy from ruin. The FTSE All-Share Index has doubled since then, but despite this stellar performance the UK equity market’s overall valuation is not egregiously expensive (although it is marginally above the long-term average).
Nonetheless, six years on from the start of QE, there are signs that the confidence this has instilled in investors is beginning to breed complacency in some areas. It is times like these that are the most dangerous for long-term investors like us. It is when traditional principles such as patience, prudence and a focus on valuation and balance sheet metrics can start to appear outmoded and unexciting. The temptation to lower our standards or even abandon them in pursuit of the apparently immediate gains on offer can be strong. By the same token, the risk of overpaying for investments is also higher and, as valuations drive long-term investment returns, the seeds of future capital loss can very easily be sown.
China presents an interesting case in point. After a seven year period of indifferent returns, the Shanghai index began to make steady gains from the middle of last year. Driven by increased optimism and no small rise in margin debt – borrowings to fund share purchases – the index went on a tear that saw it rise 150% in less than 12 months. This sucked in huge volumes of retail investors attracted by large short-term gains. Many companies also found it hard to resist the temptation to participate, with outsized gains generated from “other” income (read stockmarket speculation) finding their way into the profit and loss statements of significant numbers of Chinese businesses. In April, official statistics showed that 97% of the growth in the Chinese manufacturers’ profits came from securities investment income, and across the entire market investors have been holding stocks for an average period of just one week!
Source: Chart Shanghai index May 2014 – May 2015
However, in June, as valuations reached historic highs, the party came to an abrupt halt when the sharpest correction in the Shanghai index’s history saw the market lose nearly 30% in a single month. Declines have been so severe that nearly a quarter of all stocks on the Shanghai and Shenzhen indices have asked for their shares to be temporarily suspended to spare them further falls.
Source: Chart Shanghai index June 2015 – today
Whilst China is an emerging market and the example above represents a particularly extreme example of how swings in investor sentiment can have detrimental effects, it contains salutary lessons from which investors in all markets can and should learn. We are yet to see this sort of euphoria or panic displayed in Western markets, particularly that of the UK, however, the early warning signs are very much there.
It is in this sort of environment when what value investors refer to as ‘margin of safety’ (the difference between the market price of an investment and its true worth, and the cushion that investors have to compensate them for an investment’s risks) becomes harder to come by. When margin of safety is scarce both the upside we can expect from an investment and the insurance we have against its risks are low. Achieving a suitable balance between risk and reward is the foundation of successful long-term investing, and by consistently viewing the stockmarket in these terms investors are much less likely to be distracted by short-term exuberance.
This focus on the fundamentals rather than the froth may not be rewarded in the short-term, but in the long-run this is the surest way to safeguard capital and to ensure that full advantage can be taken when margin of safety, and hence investment opportunity, becomes abundant once again.
The Value Perspective team
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.
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.
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