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What should you do next?

“It wouldn’t surprise me to see a bubble develop in equities, perhaps over the next year or two, before a more serious correction.” That was the assessment I gave, shooting straight from the hip, to an investor in rural New South Wales recently who asked me to abandon any ‘fence sitting’ and offer my unadulterated ‘gut feel’.

In the absence of possessing a crystal ball, the equally useless gut feel was all I could offer. Of course, such musings cannot be inputs into a serious, repeatable investment strategy.

But the subject of the tension between gut feel, even if born of experience, and the execution of a highly repeatable and replicable investment strategy, driven by evidenced fundamental drivers, is the subject of today’s article.

Picking market direction consistently accurately is almost impossible. Witness, for example, the stock market's falls whenever Trump pulled ahead of Clinton during the US Presidential campaign. Of course, fears of a potential Trump victory gave way to euphoria after its confirmation.

Market rally sustained by ‘animal spirits’

The US stock market is at the late stages of a rally whose length has few precedents. Indeed, according to one definition of a bull market - a period in which the market rises 20% or more after a decline of at least 20% - the S&P 500 is enjoying its second-longest bull run ever. But equally, until recently there has been few indications of euphoria, an ingredient that tends to precede any serious correction.

Since Trump’s election the market has extended an eight-year bull run, with the Dow exceeding 21,000 for the first time amid its longest run of record closes since 1987.

Such observations are interesting but meaningless from an investment perspective except that, given historically high price multiples, if you are a buyer of the broad index today you are expecting immediate returns that history has not delivered.

The stock market might be rising because investors are paying more attention to the pro-business individuals surrounding Trump than to the President himself. Along with promised tax cuts and deregulation of the financial and energy industries, including rolling back Dodd-Frank, many suggest the market is being driven now by ‘animal spirits’.

Curiously the accelerated rally in stock markets is coinciding with a clear end to lower interest rates. Stock market rallies continue during the early phase of interest rate rises amid expectations that the economy is strengthening and earnings growth is due to emerge. But as rate rises continue, and expectations of inflation emerge, the combined effect on present values overwhelms the positive effect from earnings growth, and the market begins a correction.

It certainly appears the combination of excitement over deregulation and tax reform with its delayed delivery provides fuel for an extended period of euphoria. And if euphoria generally precedes a correction, the stage may be prepared for a script-following bubble prior to a bust.

How should an investor respond?

Should we as professional investors join others, back the truck up and fully invest, in anticipation of the expected rally, hoping to be equally adroit at exiting at precisely the right time? That sounds like ego-fuelled speculation to me.

Instead, should we follow our process, holding almost maximum cash weightings amid a general absence of bargains, knowing that it is better to be six months early than six minutes late. We have to accept being chastised for missing any ensuing rally, because we have written about it presciently here in Cuffelinks.

It is likely that some, if not many, investors will exit our funds if we miss a continuing rally. After merely treading water for the last 12 months, while the market rallied 17%, it’s hard to imagine many investors would persist with a fund manager taking fees for two years and delivering naught.

The major driver of the market’s recent returns however has been the materials sector. A booming iron ore price has rendered even the highest-cost producers profitable. Understandably, the prices of Rio, BHP and Fortescue have rallied significantly with the latter two up over 70% and 240% respectively in the last 12 months. Expectations of rising steel demand in China has lit a fire under the share prices of our domestic iron ore miners. Strangely, the price of coking coal has collapsed since hitting $308 in November last year.

Putting aside predictions of iron ore prices amid record inventory on major Chinese ports, a simple examination of the economics of the iron ore businesses, and comparing them to the economics of our preferred entities, suggests we would merely be ‘lucky idiots’ if we bought in and made money from any ongoing rise in share prices of materials stocks.

The rally is about resources, so let’s look at BHP

Imagine kicking the BHP business off in 2007 – a decade ago – with $36.7 billion of your own money (equity) and borrowings of $14.6 billion. Now suppose a net profit after tax is realised of $15.9 billion in the first year of business. It’s fair to say you would be delighted with the 43% return on your initial equity in just one year.

Following one of the biggest resource booms in history, it would be reasonable to expect that borrowing more money, reinvesting profits and injecting additional equity, to expand the business, would also expand the profits of BHP.

So, let’s suppose between 2007 and 2017, you do exactly that, investing an additional $1.4 billion of equity directly, reinvesting $34.4 billion of profits rather than paying out dividends and borrowing an additional $34.3 billion on top of the $14.6 billion already held.

Clearly it would be reasonable to hope that three times as much debt and twice as much equity would yield an increase in profits over 10 years. Unfortunately, BHP’s 2017 profit is forecast to be 42% less than it was in 2007. And in 2016, it was 87% less than in 2007! Sadly, if you were the single owner of BHP, every dollar of equity invested and reinvested by you over the last decade, has yielded a return of minus 18%.

To our way of thinking, BHP’s longer-run economics are not attractive. And the economics of the underlying business are, unsurprisingly, reflected in BHP’s share price being lower today than it was 10 years ago.

Contrast BHP with REA Group for the same period

Now assume you kick REA Group off in 2007 with $67 million of your own money (equity) and borrowings of $8 million. In the first year of business a net profit after tax is realised of $15 million. It’s fair to say you would also be delighted with this 22% return. Over the subsequent decade, you inject an additional $41 million, reinvest $573m of profits and pay off the debt.

With almost 10 times as much equity, profits in 2017 are forecast to be almost 17 times higher than in 2007. Every dollar of equity invested and reinvested by you, as the owner of REA, over the last decade, has yielded a return of 38.8%.

Warren Buffett, quoting Ben Graham, once said, “In the short run the market is a voting machine, but in the long run it is a weighing machine.” In other words, in the short run the market price might disengage from the fundamentals of the business thanks to popularity and fads. But in the long run the market price cannot escape the performance of the underlying business.

Buffet added, “If you aren’t prepared to hold the whole business for 10 years, don’t own a little piece of it for 10 minutes.”

BHP’s share price is lower than it was 10 years ago, while REA Group’s share price is more than 10 times higher than its $5.00 price of early 2007.

Sadly however, many investors miss wonderful opportunities such as REA because the share price doesn’t always reflect its superiority. In the short run, share prices can rise and fall on fads, fashions and factors that have no relevance to the underlying business.

Last year was a case in point. While BHP’s share price rose over 75% in 12 months, REA’s share price slipped 30% from its high in July 2016 to its low in November 2016. And while REA’s share price has recovered since November it remains below its July highs. Contrast this 12-month picture with the far more meaningful last decade.

BHP v REA Group, 12 months to February 2016

BHP v REA Group, 10 years to February 2016

Source: Yahoo!7 Finance

For many ‘investors’ it matters not whether the economics of the business are attractive. For those people, all that matters is that the share prices are rising, and a rising share price is a sign of a good business and a falling share price is a sign of a poor one.

Never take a cue from share prices. We might be a smaller fund manager because we don’t pick the next sector ‘rotation’ but we’ll do just fine in the long run.


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

Not a fund manager
March 14, 2017

Fund managers and analysts like to talk about their successes, but every so often they get it spectacularly wrong and remind us to treat their words with caution. Read this comment on SGH in December 2014:

"We recommended buying this personal injury law firm about a year ago. Since then, the stock is up more than 30 per cent. We continue to hold. SGH offers diversified and highly defensive earnings, which are desirable in an environment where there’s overall market weakness. It continues to roll up the UK personal injury space, which boosts earnings per share."

The rest is history. $5.86 then. $0.087 today.

SMSF Trustee
March 15, 2017

OK, so if you put a chunk of your portfolio into this you'd have lost big time. But the good quality fund managers that I know, deal with and invest with all concede that every now and then one call will go awry. That's why a lot of the skill they bring to the table is in portfolio construction - putting many stock picks together to make a portfolio that delivers over a couple of years, with inverse performance correlations among the various investments. For the odd call that goes very poorly, there are several that do well. And for a speculative micro cap like a listed law firm, the exposure would be very small so that it's demise wouldn't have much of an impact.

They might not outperform the market, but they don't blow up like you'd have us believe is possible.

Broker tip sheets are very bad at this. They just throw a lot of suggestions out there, but make no effort to help their readers build a sensible portfolio. Of course that same tip sheet probably has a lot of quite good suggestions in it as well. So i'm not really sure what your point is 'not a fund manager'.

March 03, 2017

Fund managers have really got to stop quoting Warren Buffett and Charlie Munger for that matter. And seriously it's the same hackneyed quotes. Quoting the likes of Buffett doesn't make them or their funds Buffett-like as they would have us believe.

Avoiding resource companies like BHP at all costs is stupid. Buying BHP at $14 was a no brainer. A fund manger refusing to touch resources ever is being silly. Even Buffett doesn't hold for ever either. Buy at $14 and by all means sell it and at least your investors might not be looking at fund underperformance.

Jerome Lander
March 03, 2017

Good article. Active management has really suffered recently, as usually happens when there is a concentrated rally and in the euphoric final stages of a long bull market. Nothing unusual about that.

Whether you're a speculator or an investor, it is important to know what you are. Many people who think they are investors are in fact speculators (or don't have the attributes needed to be investors).

For instance, a speculator sees iron ore and BHP go up and gets on board until they think it is going down (usually after it already has!). An investor looks at the current iron ore price, analyses the cost of production and the demand and supply, and has good reason to think that it can not and will not sustain these levels over time, and hence BHP may be at risk. They just don't know exactly when iron ore will fall and may have to be somewhat patient with their calls and their results. One is a punter and the other is partly a risk manager. Of course, somewhat strangely, they can both be right if measured over the appropriate time period despite having diametrically opposed positions.

If you're heavily into the US equity market currently, you're probably a speculator. An investor can assess that the next 10 years US equity market returns are very likely to be very modest indeed, and in no way compensates fairly for the likely volatility over this time. Even if the investor thinks the market is going up for now, it is not a prudent decision to risk it - for the odds are against you and eventually a fall will ensue.

Investors tend to emphasize longer term time periods and need to assess themselves accordingly; they often can't meaningfully be assessed over very short time periods. if you want to invest with investors, you also need to have an appropriate time period in mind or you are badly mismatched. If you don't have the patience, join the legions of speculators. They won't be too hard to find, particularly currently...

Andrew Brown
March 02, 2017

Totally accept your argument about the wasteful use of capital at BHP over the past 10 years. However, not sure where your BHP debt figures come from. A year ago the net debt was US$26.5B = A$36.6B at the time. Rather intrigued you don't look at the PRICE of BHP at the time and what you were buying for an EV of US$87B a year ago ("price is what you pay, value is what you get"). There are numerous old world businesses/industries who have shifted WAY down the cost curve in the last 2 years where you might expect some recalibrated return, subject to the vagaries of product price. This has been especially prevalent in market leaders, and assists in restricting product supply. Also need to look at regime change and its impact on capital allocation. Not being a smart-arse because I didn't own it either (and I'm not buying it now).

peter matters
March 02, 2017

Following a momentum strategy in specific stocks rather than take the looooong view of the value investor and outperform the market for one six month period every 5 years.

Brett Edgerton
March 02, 2017

Another good read, Roger... good explanation of the stresses of being a value fund manager - and I would now add Buffett's (very strong) re-engagement in the active vs passive management debate... I do suspect that you and your team will prove yourselves as enduring quality stock pickers - I just hope that flows on fully to your co-investors (to pick up on Mr Buffet's main point)...

But right now, this is where you really earn your dough - not in your short-term performance, but in how Roger Montgomery responds...

For what it's worth, I share your gut-feel on the market...

Gary M
March 02, 2017

Doesn’t say if he missed BHP and/or if he holds REA. Shouldn’t all fund managers disclose whether they hold stocks they write about?

March 02, 2017

It's a question of how much short-term underperformance can one take to get good long run total returns.


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