Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 49

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

 

RELATED ARTICLES

This cornerstone of stock market valuation has been left behind

Is your fund manager skilful or just lucky?

Four tips to catch the next 10-bagger in early-stage growth

banner

Most viewed in recent weeks

Simple maths says the AI investment boom ends badly

This AI cycle feels less like a revolution and more like a rerun. Just like fibre in 2000, shale in 2014, and cannabis in 2019, the technology or product is real but the capital cycle will be brutal. Investors beware.

Why we should follow Canada and cut migration

An explosion in low-skilled migration to Australia has depressed wages, killed productivity, and cut rental vacancy rates to near decades-lows. It’s time both sides of politics addressed the issue.

Are LICs licked?

LICs are continuing to struggle with large discounts and frustrated investors are wondering whether it’s worth holding onto them. This explains why the next 6-12 months will be make or break for many LICs.

Australian house price speculators: What were you thinking?

Australian housing’s 50-year boom was driven by falling rates and rising borrowing power — not rent or yield. With those drivers exhausted, future returns must reconcile with economic fundamentals. Are we ready?

Retirement income expectations hit new highs

Younger Australians think they’ll need $100k a year in retirement - nearly double what current retirees spend. Expectations are rising fast, but are they realistic or just another case of lifestyle inflation?

Welcome to Firstlinks Edition 627 with weekend update

This week, I got the news that my mother has dementia. It came shortly after my father received the same diagnosis. This is a meditation on getting old and my regrets in not getting my parents’ affairs in order sooner.

  • 4 September 2025

Latest Updates

Shares

Why the ASX may be more expensive than the US market

On every valuation metric, the US appears significantly more expensive than Australia. However, American companies are also much more profitable than ours, which means the ASX may be more overvalued than most think.

Economy

No one holds the government to account on spending

Government spending is out of control and there's little sign that Labor will curb it. We need enforceable rules on spending and an empowered budget office to ensure governments act responsibly with taxpayers money.

Retirement

Why a traditional retirement may be pushed back 25 years

The idea of stopping work during your sixties is a man-made concept from another age. In a world where many jobs are knowledge based and can be done from anywhere, it may no longer make much sense at all.

Shares

The quiet winners of AI competition

The tech giants are in a money-throwing contest to secure AI supremacy and may fall short of high investor expectations. The companies supplying this arms race could offer a more attractive way to play AI adoption.

Preparing for aged care

Whether for yourself or a family member, it’s never too early to start thinking about aged care. This looks at the best ways to plan ahead, as well as the changes coming to aged care from November 1 this year.

Infrastructure

Renewable energy investment: gloom or boom?

ESG investing has fallen out of favour with many investors, and Trump's anti-green policies haven't helped. Yet, renewables investment is still surging, which could prove a boon for infrastructure companies.

Investing

The enduring wisdom of John Bogle in five quotes

From buying the whole market to controlling emotions, John Bogle’s legendary advice reminds investors that patience, discipline, and low costs are the keys to investment success in any market environment.

Sponsors

Alliances

© 2025 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.