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Market serves up some savage volatility

I recently surveyed our portfolio and was stunned by the magnitude of the daily price moves. It was only 1.50pm yet APN Outdoor was up 4.32% on no announcement, TradeMe was down 2.77%, Healthscope was down 2.64% and Challenger down 1.92%.

Now, it is true that we don’t give two hoots about short-term movements. In the short run, price movements are largely random and will always be far more volatile than valuations. Prices can move on the back of sentiment and other factors that have little or nothing to do with the underlying business. A company’s valuation will change much more slowly, roughly in line with the growth in equity, from the retention of profits and redeployment of those profits at rates of return exceeding its cost of capital.

Unprecedented movements

Nevertheless, it seems that an unprecedented number of stocks have been hit with issues which have wiped significant amounts off their value, almost overnight. I cannot recall many other periods when a conga line was so populated with companies whose share prices have taken a 10-20% hit in a single day.

Recently, the announcements of the arrest of Crown Resorts executives in China caused its share price to fall almost 20% from $12.95 on 14 October 2016 to $10.40 12 days later.

Healthscope, the operator of 45 private hospitals, announced on 24 October that first quarter admissions for some procedures had slowed and that if the experience of the first quarter were repeated for the next three quarters, earnings would be flat for FY17. This caught the market, that was expecting 10% earnings growth, by surprise and the shares initially opened down 27%. As I write this, the shares are trading 24% lower than the closing price before the announcement.

Ardent Leisure’s shares have fallen by 25% following the Dreamworld tragedy, Blackmore’s shares are down 33% and Bega Cheese’s share price is 22% weaker. Unlike Woolworths, whose long-term competitive issues have resulted in a gradual weakening of its share price, the above examples have been rapid.

The questions on investors' minds are:

  1. Given examples where shares were ‘priced to perfection’, and the propensity for businesses to inevitably stumble or naturally endure weaker periods as part of the normal cycle, do these moves indicate a much deeper issue about market valuations overall?, and
  2. Are investors, who have been virtually frog marched into equities by rapidly diminishing returns from term deposits, overestimating returns and underestimating the risks of share market trading?, and
  3. Should the volatility be seen as ‘risk’ or as ‘opportunity’?

Volatility clusters

Volatility is still taught at school in the form of risk and portfolio construction, and dominates Wall Street thinking. However, our practical understanding of volatility has moved on somewhat from the days of Bachelier applying probability theory to French bonds, and the subsequent and elegant-but-flawed work of Eugene Fama’s Efficient Market Theory. Bachelier’s assumption that price changes are statistically independent and normally distributed is not borne out in the real world. The tails of the normal distribution curve fail to even remotely predict the frequency with which large price moves occur. Enter Benoit Mandlebrot, who observed that volatility tends to cluster around points in time, and after longer periods of lower volatility.

While roulette wheels spin by chance, over time the share prices of Blackmores, Woolworths or BHP don’t move by chance. But because prices can be described as if they move by chance, that has been how they’ve been described. As the aphorism goes, to a man with a hammer all problems look like a nail. And so odds and risks are being miscalculated.

The investor is best served by the work of Benjamin Graham, who without the benefit of a computer, observed that in the short run the market is a voting machine, but in the long run it is a weighing machine.

In the short run, prices will frequently move independently of the underlying business, but in the long run they cannot help but follow the accretion or diminution of the value of the underlying business.

The following chart shows the movement, over the last 60 days, in the share prices of the companies that make up the Small Ords Index. There are some remarkable changes.


Source: ASX, The Montgomery Fund

Markets at high earnings multiples

In general, the frequency and magnitude of negative share price moves suggests a general overvaluation of markets. We know for example that the CAPE Shiller P/E ratio for the US S&P500 is at the 97th percentile at the moment – in other words, the earnings multiple has only been exceeded on 3% of occasions. Similarly, the P/E ratio for the Australian Materials index is at an all-time record as it is for the S&P/ASX200 index ex banks. This is to be expected when interest rates are at multi-century lows, however forecasts of a ‘new normal’ extended period of low interest rates is simply another version of ‘this time is different’, the four most dangerous words in investing.

Investors who own companies trading on high multiples need to be on their guard, especially those in large caps offering little or no growth thanks to high payout ratios (Telstra and the banks), challenged business models (Woolworths, Wesfarmers) or cyclical industries (it will take much less time for BHP and RIO to ramp up production if the price of iron ore rises again thanks to the mine development work having already been completed during the last boom).

Investors also need to be wary of the elevated prices of infrastructure stocks such as Transurban, Sydney Airports and Auckland International Airports. They are only justified by the application of the weighted average cost of capital calculation in valuing those businesses. Due in part to low interest rates and high levels of debt, the result is a high estimated valuation. But should interest rates rise, the justification for these valuations disappears, and the two listed airports are situated on a vacant block at the end of a global cul-de-sac, which hardly justifies them being the world’s two most expensive listed airports on an EV/EBITDA basis.

When market valuations are extreme, investors need to be wary of any stumble or miss in market expectations. Inevitably, it will be through this mechanism that extreme valuations are de-rated. In time, we will look back with surprise at the low rates of returns managers were committing their investors to for extended periods.

Ultimately, however, lower prices are a good thing. All investors should see themselves as net buyers over time. It is only through this lens that they will make wise decisions with respect to quality and value.

Net buyers want lower prices in the future. With that in mind, investors should always see heightened volatility as an opportunity, as long as the long-term economics and prospects for the business are bright. In the case of an operator of 45 hospitals with the ability to manufacture more hospital beds at one-third of the cost of the government, and in a market where the number of people over the ages of 65 and 85 are growing as a multiple of the population, we believe this is the case.

 

Roger Montgomery is the Founder and Chief Investment Officer of The Montgomery Fund, and author of the bestseller ‘Value.able’. This article is general information and does not consider the circumstances of any investor.

 

11 Comments
Warren Bird
November 07, 2016

Kevin and Mark, I'm sure people used to say the same thing about a lot of companies that are no longer such great performers. EG Fairfax in the 1990's seemed a reasonably solid blue chip, with a continually improving dividend and share price that seemed quite solid at or above $4. But the fundamentals of the business changed and, while the market as a whole rebounded from the GFC price decline, Fairfax has stayed at around $1. Around an 85% drop in value. totally justified on valuation grounds.

Most share prices fluctuations are noise, but not all. Sometimes the world does change.

Some argue this means more active management. Maybe. In my view the best way to handle this is to diversify, so that you don't get stuck with too much of your portfolio in the shares that don't cope with change very well.

kevin
November 09, 2016

Hi Warren.

To an extent Iwould agree with you,there is no doubt the world and companies change.However choosing one share to prove diversification is not a great point.

The accumulation index is a fair barometer,Long time since I looked but I think the banking index was around the 70K mark,the all ords around 45K.Of course history does not predict the future.I wonder how much of that 45K has been taken in fees over those years since 1980.

Active management I have no problem with,I hope R Montgomery turns into the OZ version of Buffett,he will make himself and others very wealthy.

While I will not be around in 40 yrs from 2002 it would be interesting to see the outcome of that Westpac V super strategy,to have both and, being able to exit Westpac if fear grips, could well provide a secure retirement.

We will have to agree to disagree.

Warren Bird
November 15, 2016

Hi Kevin

using one share is exactly the right way to support an argument for diversification. For if you only have a portfolio of a few shares - far too common among many SMSF investors - and the one that permanently drops like Fairfax did is 25% of your investments, then all of a sudden you have a portfolio that is only worth 80% of what it used to be. In that situation, you'd be better off in cash.

Diversification is not just having a couple of shares in different industries or regions, but quite a few. In stock markets, where you can have a company that doubles in value or better over the years, a portfolio of maybe 30-40 should be OK. That means that an 85% fall like Fairfax will only apply to 3-5% of your fund, and the 2.5-3% loss can be offset by the 5-10% positive performance of the rest of the securities you hold. A lot of the best active equity managers have around 30 stock minimum requirements.

In corporate bond markets, which is my background, I argue that you need hundreds of individual exposures because you don't have capital upside, only the risk of default losses. So you need every individual risk in your portfolio to be a very small one. As I've argued often, this is why managed funds are better for corporate bond investing than trying to buy directly. Buying directly means you are buying predominantly risk, rather than return; buying a well managed fund means you are buying return and having risk managed appropriately.

Back on shares, these are possible to do directly if you wish. A lot of people will argue that they have had only a half dozen shares and done fine. (I think that's what you're arguing when you refer to CBA and Westpac). I say that's great, but it's also good luck. Diversification is about managing tail risk, which is where the odds of things going wrong are small, but if things do go wrong the consequences can be severe. The question to ask if you only have 5 or 6 shares is whether you could still live the lifestyle you want if one of them dropped like a stone and you therefore lost 15-20% of your portfolio - capital and income - permanently. Not just losing it in times of market volatility, where prices bounce back, but where the business collapses and doesn't recover.

So yes, owning the banks over the last 20 or 30 years has killed it. But if you'd owned 3 Australian banks and a US bank called Lehman Brothers, you'd be telling a different story.

Mark Hayden
November 15, 2016

Hi Warren - diversification is very important and I do not recommend buy and hold but I do recommend that diversification for the long-term part of the bucket can be achieved, and actually is achieved, by owning businesses covering different industries, different regions etc.

Mark Hayden
November 05, 2016

Hi All - this is noise. Purely noise. Minimal time should be wasted on noise. Businesses generate earnings from revenue less expenditure over the long-term. Shares are seen as two things (a) a part-ownership of businesses or (b) pieces-of-paper to be traded and over-analysed.

kevin
November 06, 2016

I would agree with that one.I own parts of businesses in a concentrated portfolio,I don't own any bits of paper to be traded.

CBA has been wonderful for me,reinvesting dividends for 25 yrs means every 1000 shares bought all those yrs ago are now worth around $300K.

For 25 yrs the noise has been non stop,I was wrong, I should $$ cost average,I should diversify,I should rebalance,I should pay attention to every bit of noise on a daily basis.I should listen to this, that , or the other expert.

In round numbers $6K becomes $300K over 25 yrs,I wish somebody would tell me exactly where it is that they think I went wrong.They keep telling me I should save more,I wish I had spent more.

As a real time experiment ,against stochastic analysis,I bought some Westpac shares around 2002 for $12 or $13 each,I forget now..A few yrs later it dawned on me that super started at 9% around the same time.Give it 40 yrs of real time and in 2042 after reinvesting dividends for 40 yrs I woiuld not be surprised in the least if that single outlay of $13K is worth more than they have in super .I would not be surprised if the tens of thousands they pay to experts do not produce a better return than doing something that simple.

Warren Bird
November 04, 2016

Hi Phil, yes, the market could do anything, that's for sure. But Roger has given examples where companies have had an earnings hit and have reacted strongly. I just wish to help people understand that such reactions don't have to be because of cowboys, speculators, high frequency traders or whatever, but could result simply from the natural volatility of long duration assets when the assumed inputs change. IE valuation considerations.

Let me get specific with Healthscope as the example. The most recent EPS is 0.11. To get to a share price of $3, which is where it was trading before the earnings downgrade, I factored in a year 1 earnings growth of 10% because that's what Roger said the market was expecting. According to Bloomberg the long run earnings growth assumed in the market is 5.8%, so I put that in too, from year 2 onwards. A discount rate on that earnings stream of 9.8% gets me to a share price of $3.02.

Now, if all I do is change the year 1 EPS from a 10% increase to flat, but then resume 5.8% pa and discount this at 9.8% I get a value for this earnings stream of $2.75, which is 9% lower than the starting value. That's why I made my opening comment about a 10% earnings hit having a 10% share price hit 'naturally'.

If I then increase the discount rate on Healthscope to 10.8% - ie an increase of 1% - I get a value down at $2.20. That's another 20% fall from the $2.75 revised price, which is simply the duration of the asset times the change in its discount rate.

Since this is what has actually happened with Healthscope, I don't think I'm just being theoretical. As I said, Roger might well be right that the market is wrong to think that the 10% earnings hit won't get made up somehow, or that it's wrong to think the earnings outlook is now more risky than it used to be. If he is, then the stock "should" be valued at $3 now and a value investor would go long. The market may catch up quickly and reward a long position for Roger and his fund, or it may take ages to come to the same view. Or he might be wrong and Healthscope's earnings are not as solidly based. I have no idea - I'm not a stock picker, nor an expert in Healthscope.

I'm just explaining the science side of things. I'll leave the art to others!

Phil Brady
November 04, 2016

Hi Warren,
Your example there is obviously theoretical - i.e. a 10% change in earnings impacts a stock by 10% - not necessarily, depends on how the collective market was already valuing the stock i.e. what was factored into the price. But of course price and value are different things unless you are 100% in the efficient market school.
There are many variants that people apply to Discounted Cash Flow valuations, which in its purest form is a valuation relative to an interest rate - the key word being relative. As he states his intrinsic valuation = "roughly in line with the growth in equity, from the retention of profits and redeployment of those profits at rates of return exceeding its cost of capital." - there is a difference in methods at the cost of capital and other levels ( not always purely interest rate/duration driven) and the differences can be large. Hence its an art as much as a science but that's investing. But I understand that most of the broker/analyst world values stocks at least in part, using DCF and that is what drives the market. But if you're saying as an asset class that equities are both long duration and volatile than yes can't argue with - 101 as you say. I've never seen the study on comparing the volatility of stocks selected by managers ( and I'll throw Roger in here) who seem to consistently outperform vs those that perhaps hug indices or use more rudimentary/less 'artistic' dcf valuation processes. The point being that correctly valued stocks have more margin of safety, which theoretically means less volatility over time. Basically, the fundamentals are stronger and that is recognized by the market and is apparent over time. My 2 bobs anyway.

Warren Bird
November 04, 2016

PE of 25 means duration of 25. So a 10% change in earnings in one year is naturally going to have a 10% impact on the share price. Add in a rise in the discount rate because of increased uncertainty about the future earnings growth profile and you can easily get to a 25-30% price adjustment.

Long duration assets are volatile. Nothing to do with traders or whatever, it's simple investments 1.01 isn't it?

If Roger is right and the change in the assumptions about Healthscope, for example, are invalid then the price will likely recover. If not, then the current price of $2.20 is probably fair value, rather than the old price of $3.00. I'm not an expert on the stock so don't know what the right answer is, but I do know that part of the answer is that "it depends".

http://cuffelinks.com.au/a-fixed-interest-guys-take-on-share-market-volatility/

David Roberts
November 03, 2016

The volatility can easily be blamed on high frequency traders that move the price up and down in microseconds and take out investors who have set stop losses to protect their capital. Once these investors have been taken out the HFT traders buy back in until the next attack. I like Senator Jaquie Lambie's proposal for a Financial Transaction tax which would hit HFT traders and hardly affect longer term investors.

Jerome Lander
November 03, 2016

Many people are quite reasonably predicting mid single digit returns at best over a multi year period from generic equity portfolios. Given the high risk of long only equity investment, one needs to ask whether this is really the best available option out there for most of one's portfolio.

Investors actually want positive returns and good outcomes for the risk they take, and should hence demand close to a double digit return expectation from high risk assets to warrant the risk. If they can get a higher or similar return from a different approach with lower risk, it makes a lot of sense to look at that different approach and use more of it instead, yet there is so little use of alternative investments and genuinely active approaches. Instead, the herd is increasingly investing in passive approaches!

It is quite predictable that these mainstream essentially passive portfolios will almost certainly produce very mediocre risk/return outcomes. There is a high price for investing in the status quo and crowded strategies! At least those mediocre outcomes will be delivered cheaply / you get what you pay for!

Only those who 'dare to be different' based on thinking through the issues and funding the resources needed have probability on their side and a reasonable likelihood of achieving a good outcome for the risks they take...

 

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