Value Perspective Quarterly Letter – 2Q 2016
Never make predictions, especially about the future
The Federal Reserve is now famously ‘data dependent’ when deciding whether to raise or to lower US interest rates. While we don’t share their confidence in the accuracy of preliminary estimates of economic data, a story for another time perhaps, the desire to react to the situation as it presents itself, rather than to have a pre-planned strategy, is a prudent one.
We do not have any preconceived notions as to what we will do now that the UK has voted to exit Europe. We have already seen much wailing and gnashing of teeth from businesses up and down the country. The stockmarket continues to react, moving share prices up and down depending on its estimates of the winners and losers from the situation. However, the true fair value of businesses changes very slowly over time. There may be a prolonged economic downturn, there may not. No one can say with any certainty (it won’t stop economic pundits guessing, but if they were honest they couldn’t say they knew). Either way, for most businesses with a 50 year life span, the next six months will have a relatively insignificant impact on that true fair value.
It is therefore incumbent upon us to do what we always do on the value team: to take advantage of the emotional swings of the market that are not justified by changes in the true value of companies. This means buying when others are scared, and selling when others are greedy. We do not have a playbook that we simply follow by rote. We are ‘valuation dependent’.
If financials fall by more than is justified, thereby becoming significantly cheaper and, as a consequence, significantly less risky, we are likely to be adding to our positions. If they don’t fall significantly, we won’t be. If the more stable stocks that we own in the portfolio rally significantly due to fear over the coming months, we are likely to be reducing positions. If they don’t rally significantly, we won’t be.
We don’t know where share prices will settle over the coming months. No one does. However, we will act as we always do, going wherever the value is in the market. We will buy things that others find uncomfortable, and often buy things that others currently believe to be tainted in some way. As those negative perceptions and short-term issues subside, share prices will rebound. Investors who have followed our strategies have been compensated for short-term discomfort through considerable long-term excess returns.
In truth, this is a different strategy to most of your other managers. We see very few competitors that follow this type of strategy; and that is the good news.
The next few months may be difficult. They may be volatile. However, it is our job to take advantage of that volatility and exploit the emotional reactions of the market by remaining valuation dependent.
Time in the market, not timing the market
When the market sells off sharply one day then rebounds the next, it is natural for investors to want to protect themselves from losses, or to ‘lock-in’ gains. But trying to move in and out of markets – to call the tops and bottoms – is exceptionally difficult. And, if you get your timing wrong, this can have a damaging effect on returns. Consider this example. If you had invested in a basket of global equities - the MSCI World Index - between 2005 and 2015 you would have received a return of 60%. But if you missed the 10 best days within that period then you would have lost 5%. It’s an extreme example but it demonstrates the risks of trying to time markets.
Ensuring an adequate “margin of safety” negates the need to second-guess the market
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 balance sheet strength 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.
What happens after the biggest one-day stockmarket falls?
Schroders has looked at the FTSE All-Share Index, the broadest measure of the UK stockmarket, over a decent timeframe: the past 25 years. We filtered the data to show the 20 greatest one-day falls and looked at what happened over the days and years that followed. On the worst day, during the depths of the global financial crisis on 10 October 2008, investors lost 8.3%. However, one year later, the Index had surged and returned 26%, including income paid through dividends, to investors. The returns continued: after three years the total return was 41% and after five years it was 87%. The figures apply to those holding investments before the market fell. Those who bought at the lows on those days would have seen even greater returns.
Most of the worst days were during the severe market turbulence of 2008. Look back further and the market struggled in the years after the technology bubble burst, but after five years it was 44% higher. The most notable five-year gain following one of the top-20 worst days was 126% after a 5% fall on 28 February 2009.
The returns that followed previous market sell-offs offer no firm guidance on future returns but, for long-term investors considering investment decisions during times of uncertainty, history offers food for thought.
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The Value Perspective team
The views and opinions displayed are those of Ian Kelly, Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans and Simon Adler, 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.
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.