When students of financial history look back at past cycles, they often chortle at the excesses – the madness of crowds – described. These run from the tulip bubble to TMT (technology, media, telecoms), from banks lending without assessing risks through to the mass selling of equities at the worst possible moment. Those students then think: “I won’t make those mistakes.”
The current bull market in global equities is now in its tenth year. One must be mindful that such an uninterrupted upward run may have let indiscipline creep in. Investing guidelines that work well in a bull market may have erroneously come to be considered appropriate for all market conditions.
In our opinion, a number of such principles are worth looking at with a critical eye.
Turnover
Taking the most contentious of these principles first, we think it bizarre to adopt a blanket negative attitude towards the regular buying and selling of shares. At its simplest, buying more shares when they are cheap and taking profits when a share price is ahead of itself enhances performance. The trouble is that you have to believe you have found an active fund manager skilled in identifying cheap and expensive shares…
If you have, they should be able to demonstrate that their skill exceeds in value their charges and the cost of dealing. From that point of view, any manager understands the costs of buying and selling shares and will rationally minimise turnover to avoid these costs weighing on the performance of the fund. We believe that successful active management requires some degree of portfolio turnover.
“Our favourite holding period is forever”
This point follows from the last, but there is one further implication. Any selection of investments will, over the long run, see some rising much more than others. This will necessarily mean that the distribution of risk becomes more and more lopsided over time, with a portfolio becoming increasingly dominated by the most successful investments. These often end up being the most overvalued investments in the latter stages of a bull run.
A focused portfolio performs better than a diversified one
Now, this statement is true if and only if the focused portfolio contains just successful stocks. As the bull market continues, even poorly selected stocks detract little from performance, so active managers can become overconfident. They can confuse a bull market with investment genius – everything they buy goes up, even if only a little.
When markets turn, however, the mathematics works the other way: one’s successes compensate little for the capital losses in one’s worst stocks.
Investment risk is represented by volatility (beta)
Unfortunately, many investors are now educated in fundamental analysis using a theory called the capital asset pricing model (CAPM). We agree with the core principles of this model – that an equity can be valued by comparing its cashflows with bond coupons, but the future cashflows should be discounted for the extra risk of an equity compared with a sovereign bond.
Maybe for lack of any more immediate way of assessing the risk of investing in a commercial enterprise, CAPM uses the equity risk premium multiplied by an individual stock’s beta as the discount rate premium for each equity. For those interested in these things, the equity risk premium is a number generally picked out the air from historic data of equity outperformance of bonds. Beta is the ratio of an individual stock’s covariance with the variance of the equity market as a whole. Neither of these figures may actually represent what risk one is taking with one’s capital owning a share…
Furthermore, betas seem unhelpful in practice. Bloomberg on 24 September 2019 quoted the raw beta of Thomas Cook at –0.7. This indicated a stock well placed to bring balance to a portfolio by rising when the wider market falls. Unfortunately, instead of balancing a portfolio as the theory would suggest, it went bust. Clearly, this raw beta uses the last couple of years of historic share-price movements. That figure did not identify Thomas Cook as an equity where investors were taking higher than average capital risk – something that the theory would say was indicated by a positive number over 1.
Similarly, among the highest beta stocks in the UK index is Prudential (beta 1.47), a business that has chugged along pretty solidly since 1826. Rated as much less risky (lower beta) is an investment such as SSE Group (beta 0.49), which was created in 1998 from the merger of Scotland’s hydro-electric stations and Southern’s electricity billing and generating assets, including gas and coal power stations.
Having a long-term perspective means volatility matters less
This belief may have resulted in some overconfidence. During the market wobbles in the second half of 2018, a number of funds fell rather more than the market. Markets then rebounded sharply in the first quarter of 2019. Some managers therefore argued that the best policy was to hold one’s nerve. So maybe the volatility should be ignored?
Unfortunately, the rebound has not always made up for the losses; a number of portfolios that suffered badly in the falls lagged behind the rise.
A different approach
At Artemis, we value investments against both their future cashflows and against their asset values as described in the published balance sheet. As the bull market matures, it makes sense to us to be prudent. Our hope is to protect the capital gains we have accrued by increasing our weighting in more asset-backed stocks and by trimming holdings in highergrowth companies when we believe markets may have become overexcited.
As has been seen in many equity market cycles, growth stocks will generally lead investment returns provided that they do not start from excessive valuations. Also, some low-growth companies can make fine investments if their valuation is truly bargain basement. Finally, growth stocks tend to perform better during the core years of an equity market run, while the lower-rated stocks tend to hold up better during market sell-offs.
By bringing a better balance to a portfolio, we hope to achieve strong returns when market conditions are fair and not to give up those gains too easily – even if market conditions should sour. This is the way that we believe will end up with the best real returns for investors over the long run.
Simon Edelsten is manager of the Artemis Global Select Fund
Charity Finance wishes to thank Artemis for its support with this article
