Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 240

At the start of 2018, I began to question value investing …

As the share market continued its relentless climb in early 2018, with minimal volatility, value investing was relegated to history as an anachronism from a simpler and more innocent time. Observing fund manager peers generating high double digit returns from companies whose prices weren’t even in the same universe as our valuations, I began to question the relevance of value investing myself.

Value versus momentum

However, a conversation with one peer cemented my loyalty to value investing, despite its inferior recent performance compared with momentum and growth styles. I asked my friend why he purchased a certain company given its high price. He said that my ‘problem’ was “too much focus on value and too little focus on business momentum". Apparently, it was fine picking a business with strong sales or subscriber momentum in the knowledge that as the growth continued and the story spread, other investors would join the party at higher prices and a profit could be realised.

He had made a substantial return buying stocks this way, but my next question revealed a flaw. I asked: “If you are buying well above a conservative estimate of value, how do you know when to exit?” His answer left me uncomfortable: “That’s a good question, you’ll see it ‘rolling over’.”

He meant that when the price momentum starts to slow, the price will gently 'roll over' and that would be his sell signal. If only the market were always so kind. Prices can drop sharply without warning.

Within a week, the Dow Jones Index lost 4% in a single day and at one stage was down 10%. The financial media produced some of the most breathless headlines seen in years. Many of my friend’s stocks fell as much as 16% in a few days. I wondered whether those falls constituted a ‘rolling over’ by his definition.

Jumping aboard the fads

How can a value investor win when there is nothing cheap enough to buy? The value investor holds funds in the safety of cash and watches as prices rise inexorably higher. When the optimists are winning, as they have been recently, value investing can’t hope to beat buying the ‘concepts’ that are going up the fastest.

It’s easier to join the party and buy the latest theme, fad or concept, partly because commentary surrounding the companies usually supports the rises with what appears to be entirely valid theses.

In recent months, and reminiscent of the dotcom boom, we have seen companies simply change their name or strategic focus towards blockchain, and the market has rewarded incumbent shareholders with 300% plus gains.

For example, on 21 December 2017, the Hicksville, New York-based Long Island Iced Tea company announced a “Corporate focus shift towards opportunities strategic to blockchain technologies.” The loss-making company’s shares rallied from just under US$3 to over US$15 during the day of the announcement. At their peak, the shares were trading 411% higher than their lows only a week or two earlier.

On 9 January 2018, Kodak jumped on the buzzword and launched its own cryptocurrency, KodakCoins, which are tokens for use in the blockchain-powered KodakOne photography rights management platform. Within days, Kodak’s shares were trading 390% higher.

Then eCigarette company Vapetek changed its name to Nodechain and said it would ‘explore’ Bitcoin, Ethereum, and other cryptocurrencies. The thinly traded shares jumped 360%.

These name or business changes are reminiscent of the adoption of those ending with ‘.com’ during the tech boom of 1999 and early 2000. Back then, investors mistakenly believed that new technology - technology that admittedly changed the world - would render all companies involved profitable. It is a common mistake.

Australia is far from immune from this irrational exuberance. Perfectly valid arguments are being proffered for companies with revenues of barely $1 million and market capitalisations of $1 billion.

High likelihood of poor future returns

There is no question the US market is expensive. The CAPE ratio sits at 33 times the 10-year cyclically-adjusted earnings for the S&P500. I know the CAPE ratio includes the negative earnings of the December quarter 2008, but a simple calculation that grows this year’s earnings by as much as 10% and drops out the 2008 number reveals the CAPE ratio is still at 30 times. It is higher than at any time since the 1800’s with the exception of the tech boom.

Robert Shiller himself warns that the CAPE ratio does a relatively poor job of predicting corrections, but it does an excellent job of predicting future returns. The aphorism ‘the higher the price you pay, the lower your return’ sits well with Shiller’s findings. With the CAPE ratio at record highs, we could see future returns at unappealing low single digits for many years.

What about volatility? The S&P500’s Sharpe Ratio (generally, a measure of risk-adjusted returns) is at near-record highs and at a level history shows has never been sustained. Even if the overvaluation doesn’t lead to a correction, volatility is likely to pick up. And if heightened volatility is a risk, and prospective returns are in the low single digits, the returns offered by cash offer a superior risk-adjusted alternative.

For Australian investors, while the domestic market might not seem as expensive as US indices, you can be sure of a high correlation if the US market turns down.

Timing is uncertain

I do not know with any useful accuracy when the US market will turn down more meaningfully than it did last week, but we do know some things:

  • There is little absolute value available in the Australian market for quality companies.
  • Irrational exuberance has emerged in some pockets of the market.
  • Ultra-low volatility and ultra-high returns (the S&P500 rose almost 20% in just the six months to December 2017) are not a combination that lasts very long.
  • Market corrections are usually preceded by the types of ‘shots-across-the-bow’ that we have just witnessed.
  • On a risk-adjusted basis, there may be more attractive alternatives to being fully-invested in equities.
  • History allows the recent weakness to be completely reversed and then replaced by another wildly bullish rally that sees caution thrown to the wind again and irrational exuberance itself making headlines.

On balance, caution is more appropriate than it has been at any time since 2009. Howard Marks, founder of the $100 billion Oaktree Capital, recently told clients to stay "defensive or cautious". Robert Shiller has warned "People should be cautious now." Both investors also said its not appropriate to be out of the market altogether. Our own process has arrived at a rising cash weighting but we’re still 70-75% invested. So, you could say we agree.

But we’ll leave momentum investing to those who believe they can pick the top.

 

Roger Montgomery is Chairman and Chief Investment Officer at Montgomery Investment Management. This article is general information and does not consider the circumstances of any individual.

 

RELATED ARTICLES

Forget picking the bottom and focus on value

If I get kicked out of the value investors’ club, so be it

Global search for short-term losers and long-term winners

banner

Most viewed in recent weeks

2024/25 super thresholds – key changes and implications

The ATO has released all the superannuation rates and thresholds that will apply from 1 July 2024. Here's what’s changing and what’s not, and some key considerations and opportunities in the lead up to 30 June and beyond.

The greatest investor you’ve never heard of

Jim Simons has achieved breathtaking returns of 62% p.a. over 33 years, a track record like no other, yet he remains little known to the public. Here’s how he’s done it, and the lessons that can be applied to our own investing.

Five months on from cancer diagnosis

Life has radically shifted with my brain cancer, and I don’t know if it will ever be the same again. After decades of writing and a dozen years with Firstlinks, I still want to contribute, but exactly how and when I do that is unclear.

Is Australia ready for its population growth over the next decade?

Australia will have 3.7 million more people in a decade's time, though the growth won't be evenly distributed. Over 85s will see the fastest growth, while the number of younger people will barely rise. 

Welcome to Firstlinks Edition 552 with weekend update

Being rich is having a high-paying job and accumulating fancy houses and cars, while being wealthy is owning assets that provide passive income, as well as freedom and flexibility. Knowing the difference can reframe your life.

  • 21 March 2024

Why LICs may be close to bottoming

Investor disgust, consolidation, de-listings, price discounts, activist investors entering - it’s what typically happens at business cycle troughs, and it’s happening to LICs now. That may present a potential opportunity.

Latest Updates

Shares

20 US stocks to buy and hold forever

Recently, I compiled a list of ASX stocks that you could buy and hold forever. Here’s a follow-up list of US stocks that you could own indefinitely, including well-known names like Microsoft, as well as lesser-known gems.

The public servants demanding $3m super tax exemption

The $3 million super tax will capture retired, and soon to retire, public servants and politicians who are members of defined benefit superannuation schemes. Lobbying efforts for exemptions to the tax are intensifying.

Property

Baby Boomer housing needs

Baby boomers will account for a third of population growth between 2024 and 2029, making this generation the biggest age-related growth sector over this period. They will shape the housing market with their unique preferences.

SMSF strategies

Meg on SMSFs: When the first member of a couple dies

The surviving spouse has a lot to think about when a member of an SMSF dies. While it pays to understand the options quickly, often they’re best served by moving a little more slowly before making final decisions.

Shares

Small caps are compelling but not for the reasons you might think...

Your author prematurely advocated investing in small caps almost 12 months ago. Since then, the investment landscape has changed, and there are even more reasons to believe small caps are likely to outperform going forward.

Taxation

The mixed fortunes of tax reform in Australia, part 2

Since Federation, reforms to our tax system have proven difficult. Yet they're too important to leave in the too-hard basket, and here's a look at the key ingredients that make a tax reform exercise work, or not.

Investment strategies

8 ways that AI will impact how we invest

AI is affecting ever expanding fields of human activity, and the way we invest is no exception. Here's how investors, advisors and investment managers can better prepare to manage the opportunities and risks that come with AI.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.