In the first quarter of 2009, I wrote a piece I called “The Certainty Premium.” In the panic of the Global Financial Crisis, the 3-month Treasury bill went negative for the first time in my career. It seemed odd to me that the value of a certain, though negative return was higher than the value of dozens of very solid stocks representing “despair at a discount” as I put it then. Fear was so strong that investors were paying an outrageous premium for the safety and certainty of a terrible return.
Sound familiar? It should. It’s rampant in the current market.
Historical Views of “Safe” Investments
In every challenging market, common sense seems to always take the first bullet. Emotionally-driven investor behaviour causes panic and manias, leaving some things extremely undervalued…others, remarkably overvalued. Books have been written about it (Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay comes to mind) – PhD’s in psychology spend careers studying it. Examples are famous. Back in the late 60s and early 70s investors were focused on a group of large cap, blue-chip growth stocks that became known as the Nifty Fifty. The Nifty Fifty were considered solid prospects that you never had to worry about because their future prospects were certain, thus they were safe. Enter the point that got me thinking – the concept of “safe” in investing.
“Safe” has been bothering me for a long time. Risk managers think of safe as low volatility relative to an index. Flat out wrong! Bond investors think of “safe” as the soundness of the backer, i.e., government vs. corporate and secured vs. unsecured. Getting closer. Currently, equity investors and mutual fund shareholders think of it as anything that exhibits low-volatility and steadiness even if its returns are likely to be inferior. Dangerously wrong again! Everyone wants safety, but they don’t seem to know exactly what it is. Here’s where I believe they go off course – there can be no discussion of safety that omits price. Price – what you pay for what you get – is the most important part of safety, and I mean the most important part by a mile.
The Nifty Fifty market of the mid 1970s wasn’t a bad idea, and when I look back at many of the names like Johnson & Johnson, Coca Cola, Eli Lilly, Disney, Pfizer, Pepsi etc. (there was no official list actually), many of them have performed extremely well over the past 45 years. What went wrong with the Nifty Fifty was two things:
- Frenzied crowding into the Nifty Fifty names caused investors to forget about the price they were paying, driving prices up to the point that no return was possible within anything other than a generational time horizon;
- The entire point of the Nifty Fifty was that they were “one-decision” stocks. Buy them and hold them forever were steps 1 and 2 in the instruction manual; however, after a short period of underperformance, investors abandoned the whole construct. Summed up – time horizons were affected by short-term noise.
Current Volatile Markets: Valuations May Not Be in Line with Fundamentals
The market environment we face today remains deeply affected by the Global Financial Crisis, and, still worse, subject to unknowable but certain contortions of extreme interest rate distortions. The current delusion and crowding madness is a modern version of the Nifty Fifty. The desperate hunt for low volatility, consistency and yield…the appearance of safety, in a nutshell.
The S&P 500 Utilities Index performance over the past 20 years is the poster child of the current crowding phenomenon:
The list of all-time highs is an interesting indication: all-time high Price to Earnings, Price to Book, Enterprise Value to EBITDA, Price to Cash Flow….
Telecoms are another typical low-volatility “yield play,” but they aren’t so different…dividend yields are the lowest in 10 years while EV to EBITDA valuation metrics are the highest since the peak of the housing bubble in 2006. The spike in the price of the Index now has the entire sector priced higher than at any other time since the peak of the dotcom bubble. Consumer Staples…the same. Highest P/E since the dotcom bubble though profitability is similar, growth is mostly acquired, and returns on equity are substantially lower. Global REITs are trading at levels only seen at the tippy top of the real estate bubble in 2006/2007. Now emerging market corporate debt yields are dropping as investors go further and further afield to find yield.
At least with the Nifty Fifty you had some growth to help deliver great future returns. In my view with utilities, you have a regulated return – and you’re paying far too much for the perceived safety of it. With REITs, telecoms, and staples you’re paying a large premium for non-existent growth.
Crowd-induced manias don’t end well, and we don’t expect the current version will either. Investors are out on a limb and we believe they are on the wrong side of the saw.
With perceived safe, yield-oriented stocks trading at or near all-time high multiples, I caution you to be careful. You can lose a lot of money being safe. Safety ain’t what it used to be.
The Bottom Line: Price Matters in a Sound Global Value Strategy
In the Global Value Equity UCITS Fund, we focus on buying well-managed companies with advantages, but we never forget price – what we pay for what we get. We know that price matters. We prefer to buy our straw hats in the winter – you pay a lot less than summer prices but you get the same hat. You just have to be patient. I want to emphasize that point particularly…remember, this isn’t rent money. It’s long-term money. In staples, utilities, REITs, and many bond categories, you’re paying a large premium for a steady return or a slighter higher yield but it comes with tremendous risk at these prices. If you’re reaching for yield or managing volatility right now, you’re in the herd. You just don’t know it.
There are many new and innovative things out there in investing…alternatives, smart-beta, ETF’s, allocation funds. Some of them may have valuable uses for investors; however, some of them just prove once again that well-packaged nonsense can sound like wisdom, even if the economic logic isn’t especially sound. Don’t get lost in it.
Great investing hasn’t changed that much. There remains no substitute for buying great businesses, paying the right price for them, and making sure the people who run them are working for you. Time is on your side. On Global Value, that’s where we spend all of our time.
Read more: how to stay focused on long-term value despite global market volatility.
The S&P 500 Index is a capitalization-weighted index of 500 stocks intended to be a representative sample of leading companies in leading industries within the U.S. economy. The S&P 500 Utilities Index comprises those companies included in the S&P 500 that are classified as members of the GICS utilities sector. Indices are unmanaged, and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict the performance of any investment.
Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes, regulatory and geopolitical risks. Emerging and developing market investments may be especially volatile. Eurozone investments may be subject to volatility and liquidity issues. Value investing involves the risk that undervalued securities may not appreciate as anticipated. Mid-sized company stock is typically more volatile than that of larger company stock. It may take a substantial period of time to realize a gain on an investment in a mid-sized company, if any gain is realized at all. Diversification does not guarantee profit or protect against loss.
These views represent the opinions of Randall Dishmon and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.