A SENTENTIOUS ESSAY
Reuben Beelders - Chief Investment Officer
Megan Fraser – Business Development & Marketing
[*with apologies to Publilius Syrus]
Financial markets have made a remarkable recovery after the COVID-catalysed Crash of March 2020.
Globally, equities are close to, or have exceeded, their all-time highs.
Many investors feel that it's both time and safe to return to equities; they may even think that there was in fact never any need to get out.
This has inspired us to consider how many investors’ unambiguously define their investment objective as ‘Achieving Inflation-Beating Returns’; and then, if they do, what it is that will help them to achieve this objective.
Let's start by looking at an example we can all relate to:
Scenario 1 - Bob the Builder decides to buy a house and finds a ‘great-fixer-upper’ in a highly sought after neighbourhood (such good schools!) in which homes usually sell for around R2m. The house needs some work and, furthermore, is being offered by a distressed seller and thus is on the market for R1.5m. In investment terms, we would say Bob the Builder has a margin of safety of R500 000. Assuming Bob spent R100 000 renovating this new home, it’s reasonable to expect that, should he need to sell soon, he would probably be able to sell it for at least R2m. In that case, Bob’s return on investment would be 25% (i.e. R2m/R1.6m).
Scenario 2 - Gordon Gecko, being an “I-want-it-and-I-want-it-now’ kinda guy, didn't want to spend time fixing up a home, and so purchased a similar home to Bob’s in the same area for R2m. Running into cash flow problems, he then needed to sell his property quite soon after purchase and could not get much more than the R2m he paid for it. So, he has a zero return on his investment. If he had been a little smarter, he could have placed the R2m on fixed deposit at the bank and earned around 4%, or at least have saved the interest on the R2m mortgage by not buying the house.
We’ve taken the additional costs around house-buying/selling out of the equation for the sake of simplicity.)
Benjamin Graham and David Dodd, the founders of value investing, coined the phrase margin of safety in their seminal 1934 book, Security Analysis. Graham said that "the margin of safety is always dependent on the price paid". (Wikipedia reference)
The principle of margin of safety applies to all investments and is one investors should constantly bear in mind. Because we cannot predict the future and therefore any certainty regarding any investment decisions (or any decisions really), it is prudent to make allowance for this uncertainty and factor this into the purchase price. As mentioned above, when purchasing an asset, the price you pay will determine your ultimate return. If you overpay at the point of purchase (as Gordon Gecko did having purchased at a premium) it just makes it so much more difficult/unlikely to make a decent return on your investment.
And so, back to today’s equity markets…right now we believe equities are priced at ‘R2m’ and are probably worth less than ‘R2m’. We are not alone in this view; below is a graph released by GMO Investments that indicates their expected 7 year returns which supports our view; they are of the opinion that prospective returns from most asset classes (apart from value stocks in Emerging Markets) are muted.
We believe these are the times when the challenge is to sit on your hands, ensure that your underlying investments are liquid and wait for the market to present an opportunity, as it usually does when it's overvalued.
A large chunk of the recent return in the market has come from the commonly-called ‘FANG’ stocks, i.e. those stocks generally listed in the USA that focus on social media with online business models. There are an increasing number of metrics suggesting that these stocks no longer offer significant value; to quote a Twitter post by Vincent Deluard, which reads as follows:
The question that begs asking is whether these FANG-stocks can generate the profits of the Energy, Financials, Industrials and Materials sectors combined? Do you think investors have considered that? Does common sense not dictate that one should rather buy the Energy, Financials, Industrials and Materials sectors for a more sustainable return?
The V-shaped recovery is hogging headlines…
Earlier this year, when COVID19 was predicted to be a mild intrusion in our predictable and comfortable lives, we were assured that, after a drop-off in activity, the recovery would be V-shaped and we would return to life as we knew it. Let’s just pause here…
Has life returned to ‘normal’, unchanged and business as usual? Consider travelling, holiday plans, shopping, schooling, exercising, watching live sport, shows, concerts? While we willingly acknowledge the fact that “the plural of anecdote is not evidence”, can anyone deny that there is a societal shift underway? In time, will this turn out to be the archaeology of The Shift?
Has this been priced this into our investment decisions?
In conclusion, instead of trying to put a new spin on a tried and tested storyline, we invite you to read the article we wrote in March last year in which we advocate that emotions and FOMO in particular are more than likely to cause damage to long-term wealth creation and underlying portfolios.
‘Anyone can hold the helm when the sea is calm.’
~ Publilius Syrus