Many asset managers want you to believe that they are uniquely smart – that investing is such a difficult thing to get right that it should be left to only the brightest among us. In reality, however, successful investing is really quite simple.
“Intelligence is probably the most overrated quality required to be a fund manager,” says Kevin Murphy, co-head of the global value team at Schroders.
“Napoleon had a good definition of what a military genius is: someone who can do the average thing when everybody else is losing their minds and doing some really stupid things,” he adds. “And to be a fund manager, that’s all you need. You don’t need to be super-intelligent and able to do really clever derivative things, or be a super-duper quant-type mathematical genius. You just need to be able to do the average thing when everyone else is losing their minds.”
The most important thing
A good example of this, Murphy points out, is what happened during the tech bubble in the late 1990s.
“Everyone got carried away with technology stocks and were happy to buy them at any price because the future was guaranteed,” he says. “That didn’t work out too well.”
From its peak of 5 048.62 in March 2000, the Nasdaq Index fell over 76% to bottom at 1 139.90 in October 2002. A number of companies that had listed during the internet boom went out of business. Most famously, Pets.com shut down in November 2000, just nine months after its initial public offering (IPO).
“The stock market does this occasionally,” says Murphy. “It did it in 2007 with highly indebted companies, in 2010 with Bric [Brazil, Russia, India and China] companies, and it may or may not be doing it now. Every now and again the market does something stupid and all you have to do is be able to stand back and let it pass you by, and just do the average thing. That over time will build into a much better track record than trying to be super-clever.”
What is behind this essentially simple philosophy is the central tenet of value investing – that the biggest determinant of the future return from a share is the price that you pay for it.
“Most fund managers talk about the quality businesses they invest in, the great management that they have, the wonderful barriers to entry and so on,” says Murphy. “But the problem with those kinds of businesses is that there are only a few of them in the world, and everyone is looking for them. That drives the prices of those businesses up to very high levels, and there’s a lot of research that shows that if you buy expensive companies you get very bad outcomes.”
Starting valuation matters
The chart below from the Schroders value team illustrates this using 150 years of market data. It shows the average 10-year return from US stocks based on their starting cyclically adjusted price-to-earnings (Cape) ratio.
What this shows is that the more expensive stocks are at any point, the lower their future return is likely to be. Diane Strandberg, director of international equity at Dodge & Cox, believes that understanding this is one of the three pillars of value investing.
“Valuation starting point matters,” Strandberg told the recent Morningstar Investment Conference in Cape Town. “It is the most powerful determinant of long term return – more powerful than GDP growth, earnings growth or other measures that we might look at.”
The good news for investors, she points out, is that this starting valuation is easily observable. This is why investing based primarily on starting valuations is essentially simple.
It is not, however, easy. That is because it often requires investing in parts of the market that others find unappealing, and staying away from those parts of the market where sentiment is most positive.
This can be deeply uncomfortable. However, Strandberg says that is why it is important to remember the second pillar of value investing:
“There is a vast difference between a good company and a good investment,” Strandberg says. “We all too often hear people say that we only invest in good businesses and it seems comforting. It shouldn’t be.”
Seeing out the discomfort
That is because, as Murphy points out, those companies that everybody already knows are good businesses are not going to be offering attractive valuations.
“We look in totally the opposite direction,” Murphy says. “We look for companies that are going through tough times; companies that have some challenge in their marketplaces; companies where the stock market may think that the management is just bad. We look at that and try to understand all of the risks facing that company; we try to make sure that they are priced in; that we understand them; and, most importantly, that we are compensated for those risks.”
Essentially, this means buying companies for less than they are worth. As long as analysis shows that there is little further downside risk, this is the most proven way to make money in the stock market.
It doesn’t, however, necessarily happen without going through long periods of discomfort. It may take a long time before the market prices these businesses at what they are worth.
“Those are the hard things – trying to do something different to everybody else, and then waiting,” says Murphy. “Those are the two challenges of being a value investor.”
Investors who are able to show this patience, however, will see the benefits.
“When the going gets tough – as it has in value this past decade – it is tempting to give up, but don’t,” says Strandberg. “The rewards are worth it.”
Patrick Cairns attended the Schroders International Media Conference in London as a guest of Schroders. His travel and accommodation were covered by the host company.