Because I think it possible that we could be faced with a bear market in the next year I thought it was worthwhile rereading what James Montier had to say on the subject in his excellent book Value Investing. Forewarned is forearmed when it comes to our own psychological pressures.
He starts by noting that we exhibit many of the same biases in thought that lead us to extrapolate the good times at the peak when the market is down in the dumps along with our spirits (in chapter 13).
We seem to forget the message that Abraham Lincoln brought to mind (given to King Solomon): “Solomon once charged his wise men to invent him a sentence, to be ever in view, which should be true and appropriate in all times and situations. They presented him with the words, ‘And this, too, shall pass away’. How much it expresses! How chastening in the hour of pride. How consoling in the depths of affliction” (Lincoln)
The academic researchers Shiv, Loewenstein, Bechara and Demasio in 2005 published a paper demonstrating investor psychological bias is difficult to shake off.
They ask people to play a game. Each was given $20 at the beginning. There are twenty rounds. At the start of each the participant is asked whether they want to invest. This is always $1. A fair coin is flipped. If it’s heads the “investor” gets $2.50. Tails, and the investor loses the $1.
Logically, we should all invest in every round – expected value of each round is $1.25, or a total $25 after 20 rounds. Then, there is only a 13% chance of ending up with less than $20.
Also logically, we should recognise that the outcome of a prior round should not influence the decision on whether to invest in the next round – the coin has no memory.
What they found
There were two groups of people chosen for the study
It turns out that if you tell people that one painkiller costs 10p and the other £2 in tests they will, on average, say that the more expensive one is much better at getting rid of their pain. This is the case even if the compounds are identical (this has even been tested using sugar pills demonstrating a variation on the placebo effect). Similarly, if you ask people to taste-test bottles of wine after telling them the prices they will, on average, say that the £6 one is much worse than the £60 one. This is true even if the wine is identical.
While the high price = quality heuristic works well in many situations, it frequently lets us down.
That brings us to expensive shares: could it be that our in-built psychological bias against cheapness leads us away from value shares, causing a failure to benefit from the extra return value shares offer? Do people have a dislike for things that are on sale?
We can test this by examining two groups of shares, (1) the most “admired” shares because these companies have performed well on business fundamentals and shares have risen a lot on the stock market, and (2) the “despised” group, with poor past performance both in fundamentals and their shares are lying lowly priced.
For the two groups we can judge whether the admired shares get bid up too far and the despised pushed too low by imagining that we buy a bunch of each and then track performance over the next few years.
Statman, Fisher and Anginer published such a study called “Affect in a behavioural asset pricing model” in 2008. They took those companies admired by respondents to the Fortune surveys and followed their subsequent returns.
Each year Fortune asked more than 10,000 senior executives, directors and security analysts who responded to the survey to rate the ten largest companies in their industries on eight attributes of reputation, using a scale of zero (poor) to ten (excellent).
The Admired portfolio contains the stocks of the one-half of companies with the highest scores and the Despised portfolio contains the 50% stocks with the lowest scores over the period 1982 to 2005.
You can see from the table that the admired companies had “glamour” share characteristics whereas the despised tended to have value characteristics. The admired companies are indeed better companies. But if the share prices are bid up too much they might become poor investments compared with the despised companies.
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Buffett and Munger - we are living in "the most interesting movie, by far, that we have ever seen in terms of economics", but it could end in "disaster"
I posted this account of Warren Buffett and Charlie Munger speaking at the May 2021 Berkshire Hathaway AGM last May. What they said 9 months ago has even more resonance today, now that inflation has arrived and the central banks are in quandary. So it's worth re-reading.
Buffett “The Fed moved with speed and a decisiveness on March 23rd 2020, that changed the situation, where the economy had stopped. Then Congress acted very, very big, so you have fiscal and monetary policy that responded in a way that was incredible, and it did the job...better than anybody expected. I mean, this economy right now, 85% of it, is running in super high-gear and you’re seeing some inflation.
“Interest rates have fallen to very little…If present rates were destined to be appropriate those [hi-tech] companies are bargains. They have the ability to deliver cash at rate that if you discount it back, and you’re discounting at present interest rates, stocks are very very cheap.
“Now the question is what will interest rates do over time? It’s a fascinating time; we’ve never really seen what shovelling money in on the basis that we’re doing it - on a fiscal basis following a monetary policy - with close to zero interest rates. It is enormously pleasant.
“But in economics there is always one thing to remember: you can never do one thing, you always have to say, “And then what?”.
“And we’re sending out huge sums…e.g. $1,400 cheques...and so far we’ve had no unpleasant consequences from it. People feel better – the people lending money feel very good - and it causes stocks to go up, it causes businesses to flourish, it causes an electorate to be happy.
“And we’ll see if it causes anything else. And if it doesn’t cause anything else you can count on it continuing in a very big way.
“But there are consequences to everything in economics…and people feel good and will become numb to numbers, you know, trillions don’t mean anything to anybody, and $1,400 does mean something to ‘em. So we’ll see where it all leads. Charlie and I consider it the most interesting movie, by far, that we’ve ever seen in terms of economics”
MUNGER: “Yes, and the professional economists, of course, are very surprised by what’s happened. It reminds me of what Churchill said about Clement Atlee, he said he was “a very modest man who had a great deal to be modest about”.
“And that’s exactly what happened with the professional economists. They were so calm about everything. It turns out that the world is more complicated than they thought…I don’t think any of us know what’s going to happen with this stuff. I do think there’s a good chance that this extreme conduct is more feasible than everybody thought, but I do know that if you keep on doing it without any limit it will end in disaster.”
BUFFETT: I have a quote from Keynes, it really sums up the problem:
“Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.” (The General Theory, 1939).
“Well, we’ve had a lot of people at the casino in the last year. You have millions of people set up accounts where they day trade, where they’re selling puts and calls. I would say that you’ve had the greatest increase in the number of gamblers essentially.
“They’ve had cash in their pocket, they’ve had action and they’ve had a lot of good results.
“And if they just bought stocks and held them they’d do fine.
“But the gambling impulse is very strong, and people worldwide, - and occasionally it gets an enormous shove – and conditions lead this to the place where more people are entering the casino than are leaving every day.
“And it creates its own reality for a while. And nobody tells you when the clock’s going to strike 12 and it all turns into pumpkins and mice.
“When the competition [to Berkshire looking to buy companies] is playing with other people’s money they’re going to beat us…they’ve got a lot of money, we’re not going to have much luck on acquisitions while this sort of a period continues.
“It has happened before. This is about as extreme as we’ve seen it, isn’t it Charlie?”
MUNGER: “Yes. I call it fee-driven buying. They’re not buying because it is a good investment; they’re buying because the advisor gets a fee.
“And, of course, the more of that you get, the s..............To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
We are approaching the end of bubbles in US housing, shares, bonds and commodities – Jeremy Grantham is not optimistic
Jeremy Grantham, a Brit from Doncaster (and Sheffield Uni) who made it very big in America through his deep understanding of markets (co-founder and chief investment strategist of Grantham, Mayo, & van Otterloo (GMO) in Boston), published a piece a few days ago with the title “Let the wild rumpus begin” which gives you a clue as to how bad the next few months might be.
I’ve already moved one-third of my portfolio to cash in response to bubble worries in conjunction with high inflation, and the likely response of central bankers to that down the road – it’s not going to be pretty.
I summarise Jeremy Grantham’s argument below (his 22 January 2022 essay is at https://www.gmo.com/europe/research-library/let-the-wild-rumpus-begin/).
One of the most remarkable bubbles in history
Grantham, born 1948, has spent a lifetime examining bubbles. Most are what he calls “2-sigma bubbles”. The way he calculates this is to look at the long term trend, say of house prices or share prices and then note where the current prices are in relation to the trend.
If it they are bang on the normal long-term path then there is no deviation, i.e. zero sigma. If it is a very long way from trend – up or down – it is a 2-sigma event (we’ll leave aside the mathematics).
He notes that in the past, even though 2-sigma bubbles move prices way off the long term trend all such defined bubbles in developed countries “have broken back to trend”. That is often through a crash.
Very rarely bubbles can go remarkable extremes, and be 3-sigmas away from the trend. He terms these superbubbles.
This happened in the U.S. in 1929 and 2000 and in Japan in 1989. There were also superbubbles in housing in the U.S. in 2006 and Japan in 1989.
That’s it. There are only these five instances.
Until now, that is.
In all five previous cases the superbubbles corrected “all the way back to trend with much greater and longer pain than average”.
“Today in the U.S. we are in the fourth superbubble of the last hundred years…the wild rumpus can begin at any time.”
This bubble burst could be really bad
A year ago, says Grantham, we had a standard bubble, but the economic policy response to the pandemic has helped morph the bubble to a the category of superbubble.
The situation is even more dangerous than previously because there is not only an equity bubble, but bubbles in,
Adding several bubbles together, as we see today, is very dangerous “when pessimism returns to markets, we face the largest potential markdown of perceived wealth in U.S. history.”
“As bubbles form, they give us a ludicrously overstated view of our real wealth, which encourages us to spend accordingly. Then, as..To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
Pimco's former CEO and chief investment analyst, Mohamed El-Erian (now president of Queens Cambridge and adviser to Allianz) is someone I admire for his ability to observe and synthesise data relating to the complex system that is the world economy. I've taken excepts from an article he published in the FT last week in which he suggests that because central banks have been slow to react to inflation they now have to tighten even more dramatically.
Fed and ECB still behind the inflation curve, by Mohamed El-Erian
"Central banks risk a pile-up of monetary policy tightening as inflation expectations become more embedded." In other words, he worries that people come to expect high inflation and so factor this into wage rises and price rises; then central bankers will have to be very harsh to get demand out of the economy, e.g. doubling monthly mortgages payments or cost of business loans by raising interest rates.
Already central bankers themselves are very concerned that they have let the inflation genie out of the bottle: "the key message coming out of recent meetings of central bank policymakers is that inflation is higher and more persistent than expected — and the risks to their projections are tilted to an ever greater rate of price rises."
But they realised their mistake too late as their actions so far are "partial at best, still too slow and risks an over-compensation later this year". Over-compensation I interpret here as meaning much higher interest rates to rid economies of high inflation expectations by hammering demand. Expect large rises in base rates and on long governments, and therefore corporate bonds.
There is a knock-on effect: "this continued go-slow approach [by central bankers to raising interest rates] will force [them] to tighten more this year than they would have had to otherwise" which then will damage the world economy and financial markets as recession fears grow. Higher rates of return on all financial assets will be demanded, resulting in falling share, for example (my assumption).
Wage-price spiral? "There is a risk that price and wage setting shifts from seeking..To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
I'm not, as a rule, a big fan of articles on macroeconomics. But there are historical turning points when I'm fascinated by them. We are an historic turning point as inflation tops 7% in many western countries. As night follows day central banks will respond to reduce demand in those economies. They are likely to leave it too late (initially inducing more inflation) and then, just as likely, to over react, resulting in a high probability of recession.
Stop me if I'm boring you with this subject, but you might find excepts from a Martin Wolf article published in the FT on Wednesday of interest. I think Martin Wolf has a great record of understanding "over-the-horizon" economic events.
Economic sorrows come in battalions, By Martin Wolf
Subtitle: High inflation, rising energy cost and a weakening economy are now with us, and the impending tax rise will make it worse
He starts the article by saying the BoE is now expecting the UK to show the "weakest growth of real post-tax labour incomes in more than 70 years". The average person can look forward to a fall of 2 per cent this year, followed by 0.5% fall in 2023.
The UK is particularly hard hit by rising inflation. So is America. As a result "the economy, the people and the government face hard times".
The BoE's Monetary Policy Report, out last week, noted: “Global inflationary pressures have continued to build significantly, largely driven by the sharp increases in energy prices and upward impact of the imbalance between supply of and demand for tradeable goods on their prices. On a UK-weighted basis, four-quarter world export price inflation, including energy, is expected to have risen to around 11 per cent in 2021 Q4.”
I think the first chart Martin uses shows how historic the 2022 position is. Real incomes are going to fall as badly as they did in the notable years of the mid 1970s and 2010-11. They were painful...To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
In yesterday’s newsletter I outlined James Montier’s objections to the practical use of the simplistic textbook version of discounted cash flow analysis (in his book Value Investing). Today I’ll describe his suggested alternatives.
Reverse-engineered discounted cash flow
Take the current share price and use the DCF formula to work out what is currently being implied by the market.
The resulting implied growth estimate can be considered by the analyst bringing in other factors to gain perspective. This assessment is likely to include comparison with the range of growth estimates companies generally, or this particular company, have achieved in the past.
For example, assuming a share is trading at £2.33 offering a cash flow (all paid out to shareholders) next year of 7p per share, and that the required rate of return of 8% per year for this risk class of share:
P = next year’s CF/(required return – growth rate)
233p = 7p/(0.08 – X)
X, growth = 0.05 or 5%
Now think through whether 5% is a reasonable expectation in light of the company’s competitive position, industry growth rate and past cash flow growth rates.
Problem: this approach “solves the problem of not being able to forecast the future, but it doesn’t tackle the discount rate problems outlined [in yesterday’s newsletter]”
Advantage: it provides some anchor for reasonable growth expectations. Montier says “I have seen analysts return from company meetings raving about the management and working themselves into a lather over the buying opportunity this stock represents. They then proceed to create a DCF that fulfils the requirements of a buy recommendation (i.e. 15% upside, say). They have effectively become anchored to the current price. When a reverse-engineered DCF is deployed this obsession with the current price is removed, as the discussion now takes place in terms of growth potential.”
Benjamin Graham offered two ways of approaching valuation. The first is asset based, with a particular focus on the liquidation value.
“The first rule in calculating value is that the liabilities are real but the assets are of questionable value” (Graham)
So, following Graham's net current asset value approach, you’ve seen me many times looking at UK companies’ balance sheets and deducting one-fifth of receivables and one-third of inventories because the managers may have been over-optimistic. In addition most non-current assets are valued at zero. The main exception is freehold or long-term leasehold property (Graham devalued this to only 15% of its BS estimate, but in most macroeconomic conditions I’m prepared to accept current market value – which can be more than shown on the BS)
Earnings...To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
I’ve been re-reading an important book on investing, Value Investing by James Montier, which I highly recommend if you want to separate in your mind the nonsense spouted by “expert investors” from the truly rational.
Today I want to look at what James wrote on discounted cash flow, a method we are all supposed to follow, i.e. estimate cash attributable to shareholders generated by the firm after paying for capital items, extra working capital, etc., to maintain its competitive position and (possibly) allow for growth.
James says, first, there are difficulties forecasting future cash flows
Second, we don’t know what discount rate to use. For example what equity risk premium should be in the final discount rate?
He suggests alternative approaches, that accept complex maths is not required.
Can analysts forecast?
A colleague of James’, Rui Antunes, looked at analysts’ forecasts 24 months before the actual reporting of the profits, then 23 months, then 22 months, and so on (for individual firms).
He found, on average, 24 months before the results came out the size of the error was 93%. Even one year beforehand analysts managed to miss the real profit number by 47% (USA data)
When he looked at European forecasts he found the 24 month forecast error was 95% and the 12 month forecast error 43%.
Montier says “Frankly, forecasts with this scale of error are totally worthless” (p50).
But this is not too surprising when we are dealing with many companies subject to a great deal of change such as a Tesla or Alibaba. Hence Warren Buffett’s great care to only look at companies NOT subject to great change. Anyway back to Montier and Antunes:
They separate European shares into five categories based on “value” characteristics or, at the other extreme, “growth” characteristics.
Those in group 1, the “value” shares had historically low annual growth in earnings per year, around 6%. Whereas those in group 5 grew earnings in the past at over 17% per year. Naturally, most analysts extrapolated with a small nod to the phenomenon of reversion to the mean in growth rates.
So they reckoned that the value shares would remain the slowest growers but would move a bit more to the average in the future, at 9% pa. on average.
For the growth shares in group five they forecast around 16%.
How good were those forecasts? Well, for the value shares they were pretty well spot on (on average) at around 9%. But they were way off the mark for the growth shares which went on to grow earnings at only 5% on average over the long term. Yes, below the rate for the "value" shares!
“So, it appears than analysts are most often wrong on the things they are most optimistic about!”
The discount rate
According to the university textbooks (I’ve written a few and therefore guiltily admit I’ve inflicted this on countless students) the discount rate consists of,
Bruce Greenwald, a professor focused on value investing at Columbia University’s Graduate School of Business reminds us that every time you buy an asset, such as a share, thinking that it will produce relatively high returns in the future, another investor is selling that asset thinking that it will produce relatively low returns in the future.
One is always wrong.
“Any sound investment process must, therefore begin by answering the question of why, more often than not, it places the user on the right side of the exchange?”
In other words, ask “What is my edge?”
The problem is that the vast majority of “investors” are convinced they have an edge, in the same way that in Lake Wobegon all children are above average, or most students claim a better than normal sense of humour (95% apparently).
Clearly, “the edge” you claim must stand up to rigorous scrutiny, because, equally clearly, 50% of investors will be below average.
There is hope: “There are well-documented investment approaches that have been recognised for at least 75 years which, if carefully followed, will enable any investor to outperform the market by a significant margin on average over many years…These approaches generally [fall] under the name of Value Investing.” (Greenwald)
The surprising fact is that true value investing – rather than a simplified non-thinking form – is followed by only a small minority of share buyers.
Which is good news for those who do understand and practise it, but a pity for those who either fail to put effort into learning, or who understand but opt for a more “exciting” path.
Why does value investing work?
Greenwald says studies have shown value investors outperform the market by three percent points or more per year, and the reason the outperformance persists is rooted in the psychology of individual investment behaviour:
Philip Fisher, mentor to many growth-oriented investors, concentrated on technology companies with excellent long term potential because they had developed teams of people who could continuously innovate and thus be one step ahead of competitors. When buying he asked questions like,
So long as the quality of the people in the organisation and the competitive position did not deteriorate his advice of selling shares in this type of company was succinct: almost never.
Fisher however did occasionally sell stocks, for two main reasons;
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