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Don’t go swimming naked for a short term thrill

In the latter half of calendar 2013, investors (and I apply that term loosely) rewarded those companies that were of lower quality, bidding up their prices to drive a stock market rally that made many look like geniuses.

As John F. Kennedy noted wryly, a rising tide lifts all boats. But it was Warren Buffett who later observed; it’s only when the tide goes out that you see who was swimming naked.

At The Montgomery Fund, we carve up the universe of stocks around the world by rating every listed company from A1 down to C5. A C5 company has the highest risk of going broke. Gunns Timber, Hastie Group and Autodom were all C5s for some years before plunging into stock market folklore. Elders, whose woes have seen the company search for buyers and whose share price has collapsed from over $22 in 2008 to 13 cents today, has been annually rated sub-investment grade since 2008.

Loss of focus on quality companies

But the market doesn’t always agree that investing in quality is the way to go. From 1 July 2013 to 22 January this year, what we consider high quality companies have done less well, in aggregate, than poorer quality companies.

By way of example, healthcare stocks that we rate investment-grade rose 28% from 1 July 2013 to 22 January 2014, but those we rate sub-investment grade rallied 51%. Similarly, in the consumer staples sector, those stocks rated investment-grade rose just 0.8%, while those rated sub investment-grade rallied 53.9% in aggregate. Finally, in the consumer discretionary sector, investment-grade stocks rallied 17.1%, but sub investment-grade rallied 43.1%.

Is something wrong with our rating system? No. In the long run, investing in quality at prices below our estimate of their value works, but it doesn’t work all of the time.

Think for a moment about a rather oft-heard piece of commentary that investors are “switching out of defensives into cyclicals”. This statement means it is time to expose more of your portfolio to those companies that are more acutely exposed to the vagaries of the economy.

BHP is a company regarded as cyclical. Its consensus normalised profit this year is expected to be no higher than it was seven years ago, back in 2007. Yet it has increased the amount of money it’s borrowed to help achieve this result from $14 billion to $38 billion. That’s what we call cyclical. Similarly with airlines, which I have written about before, where profits are lower than a decade ago despite massive capital and debt injections.

Unattractive economics are common amongst cyclical businesses or those that score poorly using our quality scoring approach.

The market is not always right

Regardless, many will believe that the market is always right, and whatever price the everyday investor is willing to pay for shares – irrespective of whether it’s based on poor or unqualified advice or not – is the true value of the company. Rubbish!

In my view, absolute value has had little to do with the recent trend of poor quality company outperformance. Much of it, however, can be attributed to the equally spurious investment strategy based on relative value.

Many analysts believe that if the best quality companies have already rallied hard and their aggregate price to earnings ratio (PE ratio) is, for argument’s sake, 18, and a security in the same sector can be found with a PE ratio of 12, then the rationale goes that it’s time for the stock with the PE ratio of 12 to catch up.

Our current thinking is that the market rally in the early part of 2013 eroded most of the value that was observable prior to that. There was still some relative value available among the lower quality companies, so much of the market gains more recently have been driven by a rally in the laggards.

The pattern is not without precedent. High quality companies rally first and then, desperate to generate activity, advisers encourage the latecomers to purchase those companies that haven’t caught up. But the idea that company X should have a higher share price because its peers are now at 1.3X, is logic that’s akin to suggesting a Volkswagen Kombi will beat a Ferrari in the next race because the Ferrari has won every race prior.

Unjustified by valuations and the economics of a business, the shares of some companies can indeed rally strongly and remain high for a time, but in the long run, share prices follow the economics of a business and its resultant valuation.

As Buffett also advised: “If you aren’t happy to own the whole business for ten years, don’t buy a little piece of it for ten minutes.”

This sensible piece of advice is easily forgotten by those brokerages whose need to generate profits requires activity on the part of their clients. But sound advice, which is the preserve of many brokerages most of the time, can give way occasionally to some absurd examples. Witness, for example, this recent suggestion by one international broker:

“As we are proposing a move away from quality, which has performed well in recent years … it provides the opportunity for portfolio managers to consider the merits of some of the less fundamentally-favoured stocks … as they will likely provide the most alpha ...”

Just as the steam rises from dog dung in winter, so too can the price of rubbish companies in the short run. In the long run, they fall right back again and you’d have to be a very clever gambler to know precisely when the steam will stop rising.

While the rubbish is running, it’s hard not to be tempted from one’s own strategy, especially as there’s a regret that emerges when prices for all stocks broadly rise. But don’t regret the gains that were missed. The risks aren’t worth it when the tide goes out and you’re left swimming naked.

 

Roger Montgomery is the founder and Chief Investment Officer at The Montgomery Fund, and author of the bestseller ‘Value.able

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