There are many investment maxims which get trotted out so often (“sell in May and go away”) that most would assume there is some science behind them (a bit like the current UK government’s sound bites on Covid). On closer examination, many are questionable, and some are downright misleading (a bit like the current UK government’s sound bites on Covid)!
1. “Cash on the side lines”
This is an expression used by bullish fund managers to imply that the market is going to keep rising. The picture they are trying to create is that lots of investors are not invested and therefore are holding cash but eventually fear of missing out will mean this cash goes into the market and drives prices up even further. This is mathematical nonsense. When Margaret buys a share from Meghan, she has taken her cash off ‘the side lines’ and swapped it for a share. But Meghan has relinquished her ownership of the share and receives cash which has ended up back on ‘the side-line’. The stock market is not a giant balloon that can be inflated with cash which investors somehow convert into stocks
“Every time someone says, ‘There is a lot of cash on the side-lines,’ a tiny part of my soul dies. There are no side-lines. Those saying this seem to envision a seller of stocks moving her money to cash and awaiting a chance to return. But they always ignore that this seller sold to somebody, who presumably moved a precisely equal amount of cash off the side-lines.”
My Top Ten Peeves by Clifford S Asness 2014.
2. “High valuations are justified by low interest rates”
As valuations are higher than they have ever been, I read of or hear this comment several times a week at the moment. Since I have never read a better explanation for why this is wrong than that given by John Hussman, I will let him explain it.
‘Suppose I hand you an IOU that will deliver, with certainty, $100 a decade from today. The current price is $32. Given this information, it’s simple to calculate that your expected annual return is:
($100/$32)^(1/10)-1 = 12%.
Did you need to check the level of interest rates to do that calculation? No, you did not. You can certainly compare that expected return with the prevailing level of interest rates, but that’s optional.
Now suppose I tell you that the price of the IOU is $82. Again, it’s simple to calculate that your expected annual return is:
($100/$82)^(1/10)-1 = 2%.
It’s essential to understand this point: the mapping from observable valuations to expected returns does not need to be “adjusted” for the level of interest rates. You’re free to compare the expected return with interest rates if you like, but once you have an estimate (or sufficient statistic) of future cash flows and the current price, nothing else is required to estimate the expected return.
The reason so many investors and even professionals are confused on this point is that they have conflated it with an entirely different problem. Suppose that we know the expected cash flows but the current price is unobservable or excluded from our calculations. What’s the “fair” price we should pay for the security? Well, it depends on the rate of return we want to earn. At this point, you might look around and say, well interest rates are so-and-so, and I’d like to get a few percent more than that, so maybe I’d be ok with a 4% return. Fine. Now we can plug that in, and we get a target price of:
$100/(1.04)^10 = $67.56.
So, here’s the rule. If you’ve got a reliable valuation measure that relates the current price to some fundamental that’s reasonably representative of future cash flows, the expected return can be estimated directly. Comparing that expected return to interest rates comes later and is optional.
In contrast, if you’ve got an estimate of future cash flows and you don’t know the price, you can use the level of interest rates, if you wish, to help you decide what a “fair” return might be, and the price that would produce that expected return.
Don’t confuse those two problems.
Source: Alice’s Adventures in Equilibrium by John Hussman June 2021.
If you buy equities on high valuations, history says that you should expect to earn low returns. Now if you are happy with those returns because interest rates are also low, all well and good. What we believe is wrong is to buy equities with high valuations and expect to earn long run average returns because interest rates are low.
3. “It’s time in the market not timing the market that counts”
Remember, if you take your money out of the market, your wealth manager earns no fees and hence they have a very strong incentive to encourage you to always be fully invested. This adage about always being fully invested is usually accompanied by some research that looks at how much your returns suffer if you miss out on the ten best days. Funnily enough, they never extend this analysis to look at how much your returns were improved by missing the ten worst days. Nor will it use a market such as Japan starting in 1990 where being out of the market really wouldn’t have harmed your returns in the last thirty years.
Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.
Nor will it tell you that the return on the S&P500 lagged that of T-Bills for:
- 18 years from August 1929 to May 1947
- 21 years from November 1961 to October 1982
- 13 years from March 2000 to April 2013
Source: Alice’s Adventures in Equilibrium by John Hussman June 2021
In total that’s 52 years out of an 84-year time span. What all these periods have in common is that the starting valuations were very high (although not as high as they are today). The idea that you should be fully invested regardless of valuation is therefore a highly questionable one.
4. “This (market, sector, stock) is Uninvestable”
This is a phrase often uttered at the capitulation stage of the cycle and thus frequently ahead of spectacularly good returns. This was often said about tobacco companies in 2000 on the basis that a) they weren’t technology companies and b) their industry was considered to be in structural decline. They went on to earn 18% p.a. total returns for the next decade. It was said about banks in 2008 and it is currently being said about energy companies.
The ‘uninvestable’ theme is often illustrated in the covers of business magazines such as ‘The Death of Equities: How Inflation is Destroying the Stock market’ which was produced by Business Week in August 1979. The stock market produced total returns of 8200% in the next four decades.[1] Not to be outdone, The Economist cover ‘Drowing in Oil’ appeared in 1999 when the oil price was $17 and in the following years it rose to $180. Those convinced that inflation is transitory should probably be worried given that in 2019 a Business Week cover asked, ‘Is Inflation Dead?’ whilst an Economist cover similarly stated ‘The End of Inflation?’.
When sentiment is so bad that investors start using the ‘uninvestable’ word, it often means the worst has been discounted and any outcome better than terrible can produce substantial returns.
5. “Value investing is dead”
I hear this a lot at the moment from the ‘growth’ or ‘quality’ investors who have done well in the recent bubble and are keen to keep investors with them in some of the most expensive stocks in stock market history. One only has to define value investing as the act of buying something for less than it is worth to realise what a ludicrous statement this is (who in their right mind would knowingly pay more for something that it is worth?) Quality and growth are both inputs into a calculation of value. The very idea that you can ignore valuation just because a company has a high growth rate or is good quality is manifestly nonsense. If you believe that a company can grow at 20% p.a for the next decade that’s fine, but you should still plug that assumption into your valuation and compare it to the price you are paying. Secondly, you should look at the base rate of how many companies in history have been able to achieve this in order to consider the probability of your forecasts being correct. Finally, you should consider the potential downside if your rosy predictions fail to materialise. If you take all though those into consideration and the current share price is below your estimate of the value of the business, then go ahead but I would argue that you are a value investor.
Charlie Munger was quoted as saying ‘You show me the incentive, I’ll show you the behaviour’. When phrases such as ‘value investing is dead’ or ‘time in the market’ are trotted out, the first thing you should ask is whether the speaker or writer has a vested interest to be saying this. If that is the case, you may well find that although a maxim is frequently repeated, it is not backed by any empirical evidence whatsoever and hence you should take many of these adages with a pinch of salt.
[1] The Death of Equities 40th Anniversary by Barry Ritholz August 2019
Unless otherwise stated, all opinions within this document are those of the RWC UK Value & Income team, as at 5th August 2021.
