Volatile World Markets are Telling us to Stay Cautious

For the last year or so, we’ve been warning readers that the extended run-up in world markets was getting closer to the end. While October’s price falls saw some of the froth blown off the top, we think this may be just the beginning of a long grind lower.

With the high-momentum growth stocks falling in a heap – just as we warned they would – investors may be considering whether value has emerged. Before jumping in, however, it may be worth considering whether the circumstances that drove their share prices to giddy heights in the first place and unjustified by realistic prospects are likely to return.

It has been a tough road for value investors in the last couple of years. Buffett’s Berkshire Hathaway, run arguably by the world’s wealthiest fund manager, Warren Buffett, now has over US$125 billion in cash, representing just over a quarter of its market cap, and earning virtually no interest. When Buffett noted, at Berkshire’s AGM back in March, that

“an attractive price is a requirement that proved to be a barrier to virtually all deals we reviewed in 2017”,

I felt his frustration.

I can remember in 1999 and 2000 when Berkshire Hathaway had underperformed the Dow Jones by a massive 40 per cent and commentators and tech stock traders said that he was ‘washed up’, that he didn’t understand the ‘new paradigm’, and that he should retire. Then, of course, the tech bubble burst, Berkshire returned to outperformance and everyone said he was a genius. In reality, he hadn’t changed anything that he was doing; he simply stuck to the tenets of value investing.

At Montgomery, we too are holding a large balance of cash and have been left behind by peers who were happy to ‘invest’ in long shots simply because long shots were winning. As their gains accumulated over the last year or so, we looked more and more out of step.

But now, the tables are turning, and our optimistic friends’ accumulated outperformance is being rapidly unwound.

Stocks we have warned investors about over the course of the year, such as Kogan and after pay, are now down 49 per cent and 40 per cent respectively. That’s a crash in anyone’s language. Others mentioned include Wasatch (-34 per cent), Append (-31 per cent), A2 Milk (-30 per cent), Xero (-20 per cent), Altium (-26 per cent) and Push pay (-19 per cent). And it may not be over just yet.

The job of an investor, as opposed to a share price speculator, is to purchase at a rational price, a part share of an easy to understand business, whose earnings are virtually certain to be materially higher in five, ten, or fifteen years.

It’s the ‘rational price’ part that has been missing during the rally of the above names earlier this year.

The Shiller CAPE ratio, which compares the inflation-adjusted S&P500 to ten-year average earnings is at 33.07 – the highest since 1870 with the exception of Tech Boom 1.0. The ratio isn’t particularly good at predicting crashes, however, so don’t assume there’s a correction coming. What it does very well is predicting whether the next ten years’ average returns will be high or low. Whenever the ratio is below 15 times earnings, returns from investing in the S&P500 over the subsequent decade have been very good. Whenever the ratio is very high, returns have been very low, even negative. Today, at 33.07 times earnings, the CAPE Ratio is very, very high indeed. 

It is also worth keeping in mind that circa $500 billion of high yield CCC-rated credit (aka Junk) is due for refinancing next year. The amount represents a credit market record and interest rates have risen meaningfully since the debt was issued. A repricing of this debt is highly likely, and while we have known about this event for two years, we are now much closer to it. The US high yield credit market is larger and riskier than prior to GFC and increasing leverage ratios and a higher proportion of covenant-lite debt is evident in the US, Europe and in Asia.

This latter observation is perhaps not surprising since it has now been a decade since the GFC – more than enough time to forget with, as Howard Marks noted,

“the reasons for stringent credit standards receding into the past”.

It’s worth keeping in mind that the current US economic recovery is the weakest since WWII and therefore many of the usual excesses requiring correcting have not been built in. However, the aforementioned credit binge, lax lending standards and plain nonsense in the prices of many growth stock hopefuls are elements of the sort of froth that can typically be identified ahead of past corrections.

A worthwhile way to think about whether current excesses exist, and whether they should be corrected, is to consider what low interest rates have forced investors to do. Punitive rates on cash – set by central banks – have caused investors to move much higher up the risk spectrum than they normally would. This is reflected in the record prices paid for non-income-producing assets such as art, stamps and collectible cars as well as the willingness to fund loss-making start-ups, such as Uber for nine years, through private equity. So, while broad-based optimism isn’t evident in the community, it is evident in asset prices, reflecting the abandonment of risk aversion.

Another way to examine the presence of optimism is with simple arithmetic. Greenlight Capital’s David Einhorn, who has admittedly lost his investors about 25.7 per cent year to date, recently offered simple math’s to highlight the absurdity some investors are willing to support in an attempt to beat cash rates;

“The current market view is that profitless companies with 20-30 per cent top-line growth are worth 12x-15x revenues, while profitable companies that lack that level of opportunity are worth only 5x-8x after tax earnings. As an arithmetic exercise, if you pay 12x revenues for a company that eventually makes a 10 per cent after tax margin and trades at a 20x P/E, the company has to sustain a 25 per cent growth rate for 8 years for you to break even, and for 12 years for you to make an 8 per cent IRR (requiring 15x revenue growth). If the company is increasing the share count by paying employees in stock, the math gets worse.”

When investors are buying an asset, whose net yield is below cash, they are receiving a lower return but taking on more risk. The risk-adjusted returns on cash start to look more attractive. Of course, because rates have been so low for so long, nobody seems to believe that the world could change. But changing it is, and the recent share price falls we have been warning about, may be just the beginning of a long grind lower.

For that reason, our position remains unchanged from a year ago, stay cautious.

"It has been a tough road for value investors in the last couple of years"

Roger Montgomery, Montgomery Investment Management