“These are not the investments your portfolio manager chooses for the Fund. A wildly fluctuating dollar selling for 40 or 50 or 60 cents will always remain more attractive – and far less risky. As for my loneliness at the lunch table, it has always been a maxim of mine that while capital raising may be a popularity contest, intelligent investment is quite the opposite. One must therefore take some pride in such a universal lack of appeal.”
Although it now seems to be an old-fashioned notion, buying a share in a company used to be considered as an act of buying ownership of a future stream of income from a business. A sound investment strategy was thought to be one that tried to pay less than the net present value of that income stream in order to provide the investor with a reasonable return and a margin of safety. Today, investing for many seems to be focused on paying significantly more than the intrinsic value of a business in the hope that they can sell it on to ‘a greater fool’ at an even higher price. As the Robinhood traders in Gamestop have just discovered, however, that can go badly wrong when the music stops, and you are left holding a share priced at significantly more than it is worth with no-one willing to buy it from you.
It should be self-evident that there is an inverse correlation between the price you pay for that future stream of income and the return you get on it. To keep matters simple, let’s use just one income payment of £1 in five years’ time. If you pay 33p for it today, your return is 25% p.a. If you pay 75p your return is 6% p.a. and if you pay £1.1 your return is -2% p.a.
One thing that should jump out from this is that lower interest rates do not make that stream of income more valuable. There is no change in the £1 that you receive in five years’ time. When you hear people say that high share prices are “justified by lower interest rates”, what they are really saying is that the very low return expected from buying shares at high valuations looks acceptable relative to the very low return that you could get from owning bonds at very low yields. It does not mean you should expect the long run average return from equities if you buy them at high valuations, in fact you should probably expect to earn considerably less.
Valuing equities would be simple if we had just one payment and we knew with certainty its value in five years’ time but of course that is not the case. Whilst assumptions have to be made about future growth rates and terminal values, it is worth remembering that your returns as an equity investor come from income, plus growth, plus any change in valuation during your holding period. If you buy a stock on a 5% dividend yield, that grows its dividend at 3% and get no rerating, your return is 8%.
Conversely, if you buy a stock on a 1.5% dividend yield, even if it grows at 4% p.a. your return is 5.5% p.a. but if it just de-rated to 2% at the end of the five year period, your return is zero, i.e. that small de-rating is enough to wipe out all of the five years of 5.5%.
There are two lessons from this; 1) Investors often underestimate the extent to which their returns can be harmed by de-rating and 2)Re-rating is not a sustainable source of returns, once a share has rerated from a 4% yield to a 1% yield, there isn’t that much farther to go.
- Switching out of the UK to US equities or global equities
Source: The Speculative V by John Hussman, January 2020.
Source: RWC Partners, 31st December 2020.
2. Switching out of Value into Growth funds[5].
Source:RWC Partners, 31st December 2020.
Conclusion
[1] https://acquirersmultiple.com/2018/08/michael-burry-risk-is-not-defined-by-volatility/
[2] Equity funds were the best-selling asset class in December 2020 with £2.5bn in net retail sales, buoyed by strong inflows into Global equity funds of £1.5bn. Funds investing in North America were the second most popular by region, taking in £504m.
[3] The Speculative V by John Hussman January 2020
[4] Superinvestors and the Art of Wordly Wisdom interview with John Hussman Jan 2021.
[5] ‘Meanwhile, the worst-selling Investment Association sector in December 2020 was UK Equity Income with an outflow of £501m, as the UK remained out of favour. Overall, UK funds saw net retail outflows of £845m’. Investment Week 4 Feb 2020.
[6] See, for instance, GMO, Research Affiliates or Hussman Advisors.
[7] See for instance ‘Do emotions overwhelm probability in decision making’ by Joe Wiggins April 2017.
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