Questionable investment maxims

July 27, 2021

12:30 am

There are many investment maxims which get trotted out so often (“sell in May and go away”) that most would assume there is some science behind them (a bit like the current UK government’s sound bites on Covid). On closer examination, many are questionable, and some are downright misleading (a bit like the current UK government’s sound bites on Covid)!

 

  1. “Cash on the side lines”

 

This is an expression used by bullish fund managers to imply that the market is going to keep rising. The picture they are trying to create is that lots of investors are not invested and therefore are holding cash but eventually fear of missing out will mean this cash goes into the market and drives prices up even further. This is mathematical nonsense. When Margaret buys a share from Meghan, she has taken her cash off ‘the side lines’ and swapped it for a share. But Meghan has relinquished her ownership of the share and receives cash which has ended up back on ‘the side-line’. The stock market is not a giant balloon that can be inflated with cash which investors somehow convert into stocks

 

“Every time someone says, ‘There is a lot of cash on the side-lines,’ a tiny part of my soul dies. There are no side-lines. Those saying this seem to envision a seller of stocks moving her money to cash and awaiting a chance to return. But they always ignore that this seller sold to somebody, who presumably moved a precisely equal amount of cash off the side-lines.”

My Top Ten Peeves by Clifford S Asness 2014

 

  1. “High valuations are justified by low interest rates”

 

As valuations are higher than they have ever been, I read of or hear this comment several times a week at the moment. Since I have never read a better explanation for why this is wrong than that given by John Hussman, I will let him explain it.

 

‘Suppose I hand you an IOU that will deliver, with certainty, $100 a decade from today. The current price is $32. Given this information, it’s simple to calculate that your expected annual return is:

($100/$32)^(1/10)-1 = 12%.

Did you need to check the level of interest rates to do that calculation? No, you did not. You can certainly compare that expected return with the prevailing level of interest rates, but that’s optional.

Now suppose I tell you that the price of the IOU is $82. Again, it’s simple to calculate that your expected annual return is:

($100/$82)^(1/10)-1 = 2%.

It’s essential to understand this point: the mapping from observable valuations to expected returns does not need to be “adjusted” for the level of interest rates. You’re free to compare the expected return with interest rates if you like, but once you have an estimate (or sufficient statistic) of future cash flows and the current price, nothing else is required to estimate the expected return.

The reason so many investors and even professionals are confused on this point is that they have conflated it with an entirely different problem. Suppose that we know the expected cash flows but the current price is unobservable or excluded from our calculations. What’s the “fair” price we should pay for the security? Well, it depends on the rate of return we want to earn. At this point, you might look around and say, well interest rates are so-and-so, and I’d like to get a few percent more than that, so maybe I’d be ok with a 4% return. Fine. Now we can plug that in, and we get a target price of:

$100/(1.04)^10 = $67.56.

So, here’s the rule. If you’ve got a reliable valuation measure that relates the current price to some fundamental that’s reasonably representative of future cash flows, the expected return can be estimated directly. Comparing that expected return to interest rates comes later and is optional.

In contrast, if you’ve got an estimate of future cash flows and you don’t know the price, you can use the level of interest rates, if you wish, to help you decide what a “fair” return might be, and the price that would produce that expected return.

Don’t confuse those two problems.’

Source: Alice’s Adventures in Equilibrium by John Hussman June 2021

 

If you buy equities on high valuations, history says that you should expect to earn low returns. Now if you are happy with those returns because interest rates are also low, all well and good. What we believe is wrong is to buy equities with high valuations and expect to earn long run average returns because interest rates are low.

 

  1. “It’s time in the market not timing the market that counts”

 

Remember, if you take your money out of the market, your wealth manager earns no fees and hence they have a very strong incentive to encourage you to always be fully invested. This adage about always being fully invested is usually accompanied by some research that looks at how much your returns suffer if you miss out on the ten best days. Funnily enough, they never extend this analysis to look at how much your returns were improved by missing the ten worst days. Nor will it use a market such as Japan starting in 1990 where being out of the market really wouldn’t have harmed your returns in the last thirty years.

Source:  Bloomberg, as at 22 August 2021

Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

 

Nor will it tell you that the return on the S&P500 lagged that of T-Bills for

  • 18 years from August 1929 to May 1947
  • 21 years from November 1961 to October 1982
  • 13 years from March 2000 to April 2013

Source: Alice’s Adventures in Equilibrium by John Hussman June 2021

 

In total that’s 52 years out of an 84-year time span. What all these periods have in common is that the starting valuations were very high (although not as high as they are today). The idea that you should be fully invested regardless of valuation is therefore a highly questionable one.

 

  1. “This (market, sector, stock) is Uninvestable”

 

This is a phrase often uttered at the capitulation stage of the cycle and thus frequently ahead of spectacularly good returns. This was often said about tobacco companies in 2000 on the basis that a) they weren’t technology companies and b) their industry was considered to be in structural decline. They went on to earn 18% p.a. total returns for the next decade. It was said about banks in 2008 and it is currently being said about energy companies. The ‘uninvestable’ theme is often illustrated in the covers of business magazines such as ‘The Death of Equities: How Inflation is Destroying the Stock market’ which was produced by Business Week in August 1979. The stock market produced total returns of 8200% in the next four decades.[1] Not to be outdone, The Economist cover ‘Drowing in Oil’ appeared in 1999 when the oil price was $17 and in the following years it rose to $180. Those convinced that inflation is transitory should probably be worried given that in 2019 a Business Week cover asked, ‘Is Inflation Dead?’ whilst an Economist cover similarly stated ‘The End of Inflation?’.

When sentiment is so bad that investors start using the ‘uninvestable’ word, it often means the worst has been discounted and any outcome better than terrible can produce substantial returns.

 

  1. “Value investing is dead”

I hear this a lot at the moment from the ‘growth’ or ‘quality’ investors who have done well in the recent bubble and are keen to keep investors with them in some of the most expensive stocks in stock market history. One only has to define value investing as the act of buying something for less than it is worth to realise what a ludicrous statement this is (who in their right mind would knowingly pay more for something that it is worth?) Quality and growth are both inputs into a calculation of value. The very idea that you can ignore valuation just because a company has a high growth rate or is good quality is manifestly nonsense. If you believe that a company can grow at 20% p.a for the next decade that’s fine, but you should still plug that assumption into your valuation and compare it to the price you are paying. Secondly, you should look at the base rate of how many companies in history have been able to achieve this in order to consider the probability of your forecasts being correct. Finally, you should consider the potential downside if your rosy predictions fail to materialise. If you take all though those into consideration and the current share price is below your estimate of the value of the business, then go ahead but I would argue that you are a value investor.

 

Charlie Munger was quoted as saying ‘You show me the incentive, I’ll show you the behaviour’. When phrases such as ‘value investing is dead’ or ‘time in the market’ are trotted out, the first thing you should ask is whether the speaker or writer has a vested interest to be saying this. If that is the case, you may well find that although a maxim is frequently repeated, it is not backed by any empirical evidence whatsoever and hence you should take many of these adages with a pinch of salt.

 

Unless otherwise stated, all opinions within this document are those of the RWC UK Value & Income team as at 05 August 2021.

 

[1] The Death of Equities 40th Anniversary by Barry Ritholz August 2019

Unless otherwise stated, all opinions within this document are those of the RWC UK Value & Income team, as at 5th August 2021. 

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In case you missed it…

The term “RWC” may include any one or more RWC branded entities including RWC Partners Limited and RWC Asset Management LLP, each of which is authorised and regulated by the UK Financial Conduct Authority and, in the case of RWC Asset Management LLP, the US Securities and Exchange Commission; RWC Asset Advisors (US) LLC, which is registered with the US Securities and Exchange Commission; and RWC Singapore (Pte) Limited, which is licensed as a Licensed Fund Management Company by the Monetary Authority of Singapore.


RWC may act as investment manager or adviser, or otherwise provide services, to more than one product pursuing a similar investment strategy or focus to the product detailed in this document. RWC seeks to minimise any conflicts of interest, and endeavours to act at all times in accordance with its legal and regulatory obligations as well as its own policies and codes of conduct.

This document is directed only at professional, institutional, wholesale or qualified investors. The services provided by RWC are available only to such persons. It is not intended for distribution to and should not be relied on by any person who would qualify as a retail or individual investor in any jurisdiction or for distribution to, or use by, any person or entity in any jurisdiction where such distribution or use would be contrary to local law or regulation.


This document has been prepared for general information purposes only and has not been delivered for registration in any jurisdiction nor has its content been reviewed or approved by any regulatory authority in any jurisdiction. The information contained herein does not constitute: (i) a binding legal agreement; (ii) legal, regulatory, tax, accounting or other advice; (iii) an offer, recommendation or solicitation to buy or sell shares in any fund, security, commodity, financial instrument or derivative linked to, or otherwise included in a portfolio managed or advised by RWC; or (iv) an offer to enter into any other transaction whatsoever (each a “Transaction”). No representations and/or warranties are made that the information contained herein is either up to date and/or accurate and is not intended to be used or relied upon by any counterparty, investor or any other third party.


RWC uses information from third party vendors, such as statistical and other data, that it believes to be reliable. However, the accuracy of this data, which may be used to calculate results or otherwise compile data that finds its way over time into RWC research data stored on its systems, is not guaranteed. If such information is not accurate, some of the conclusions reached or statements made may be adversely affected. RWC bears no responsibility for your investment research and/or investment decisions and you should consult your own lawyer, accountant, tax adviser or other professional adviser before entering into any Transaction. Any opinion expressed herein, which may be subjective in nature, may not be shared by all directors, officers, employees, or representatives of RWC and may be subject to change without notice. RWC is not liable for any decisions made or actions or inactions taken by you or others based on the contents of this document and neither RWC nor any of its directors, officers, employees, or representatives (including affiliates) accepts any liability whatsoever for any errors and/or omissions or for any direct, indirect, special, incidental, or consequential loss, damages, or expenses of any kind howsoever arising from the use of, or reliance on, any information contained herein.


Information contained in this document should not be viewed as indicative of future results. Past performance of any Transaction is not indicative of future results. The value of investments can go down as well as up. Certain assumptions and forward looking statements may have been made either for modelling purposes, to simplify the presentation and/or calculation of any projections or estimates contained herein and RWC does not represent that that any such assumptions or statements will reflect actual future events or that all assumptions have been considered or stated. Forward-looking statements are inherently uncertain, and changing factors such as those affecting the markets generally, or those affecting particular industries or issuers, may cause results to differ from those discussed. Accordingly, there can be no assurance that estimated returns or projections will be realised or that actual returns or performance results will not materially differ from those estimated herein. Some of the information contained in this document may be aggregated data of Transactions executed by RWC that has been compiled so as not to identify the underlying Transactions of any particular customer.


The information transmitted is intended only for the person or entity to which it has been given and may contain confidential and/or privileged material. In accepting receipt of the information transmitted you agree that you and/or your affiliates, partners, directors, officers and employees, as applicable, will keep all information strictly confidential. Any review, retransmission, dissemination or other use of, or taking of any action in reliance upon, this information is prohibited. The information contained herein is confidential and is intended for the exclusive use of the intended recipient(s) to which this document has been provided. Any distribution or reproduction of this document is not authorised and is prohibited without the express written consent of RWC or any of its affiliates.

Changes in rates of exchange may cause the value of such investments to fluctuate. An investor may not be able to get back the amount invested and the loss on realisation may be very high and could result in a substantial or complete loss of the investment. In addition, an investor who realises their investment in a RWC-managed fund after a short period may not realise the amount originally invested as a result of charges made on the issue and/or redemption of such investment. The value of such interests for the purposes of purchases may differ from their value for the purpose of redemptions. No representations or warranties of any kind are intended or should be inferred with respect to the economic return from, or the tax consequences of, an investment in a RWC-managed fund. Current tax levels and reliefs may change. Depending on individual circumstances, this may affect investment returns. Nothing in this document constitutes advice on the merits of buying or selling a particular investment. This document expresses no views as to the suitability or appropriateness of the fund or any other investments described herein to the individual circumstances of any recipient.


AIFMD and Distribution in the European Economic Area (“EEA”)


The Alternative Fund Managers Directive (Directive 2011/61/EU) (“AIFMD”) is a regulatory regime which came into full effect in the EEA on 22 July 2014. RWC Asset Management LLP is an Alternative Investment Fund Manager (an “AIFM”) to certain funds managed by it (each an “AIF”). The AIFM is required to make available to investors certain prescribed information prior to their investment in an AIF. The majority of the prescribed information is contained in the latest Offering Document of the AIF. The remainder of the prescribed information is contained in the relevant AIF’s annual report and accounts. All of the information is provided in accordance with the AIFMD.


In relation to each member state of the EEA (each a “Member State”), this document may only be distributed and shares in a RWC fund (“Shares”) may only be offered and placed to the extent that (a) the relevant RWC fund is permitted to be marketed to professional investors in accordance with the AIFMD (as implemented into the local law/regulation of the relevant Member State); or (b) this document may otherwise be lawfully distributed and the Shares may lawfully offered or placed in that Member State (including at the initiative of the investor).


Information Required for Distribution of Foreign Collective Investment Schemes to Qualified Investors in Switzerland


The representative and paying agent of the RWC-managed funds in Switzerland (the “Representative in Switzerland”) is Société Générale, Paris, Zurich Branch, Talacker 50,

P.O. Box 5070, CH-8021 Zurich. In respect of the units of the RWC-managed funds distributed in Switzerland, the place of performance and jurisdiction is at the registered office of the Representative in Switzerland.

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