Our last missive of 2017 comes (as it normally does) after our final “Wise Man” economics and strategy meeting of the year. And with it we try and look back on the year just passed, and deduce what lessons it might bring us for the future. Revera blog-watchers will realise that we have been more muted in the second half of this year than perhaps in previous periods. This was not so much because we had nothing to say; more that we had nothing to say that we hadn’t already said a couple of times before. The second half of 2017 at an aggregate level has been serene, even if many individual companies have hit speed bumps along the way. Perhaps the most startling statistic of the year has been that, on a total return basis, the largest pull back in the UK equity market at any point in 2017 has been only 3%. This represents supreme confidence, or remarkable complacency.
In many ways, it is not difficult to rationalise the gains that have been made on all major equity markets this year. We have seen a synchronised upswing in economic activity across the globe, which has been fuelled by industrial production, and as a consequence, an uptick in the capex cycle for the first time in a number of years. Monetary policy has remained accommodative – even in the regions it is tightening, and fiscal policy has been largely neutral; with promises of fiscal loosening to come next year and beyond in the United States. Meanwhile, other asset classes offer a paucity of return; equities may look relatively expensive compared to history, but the prospect of growing earnings and dividends over time offers the investor a path to redemption if he or she overpays in the short term.
As we look back on our experience over the year, the general sentiment is one of modest contentment. Investment performance has been respectable, despite the persistence of a number of investment themes that wouldn’t typically play to our strengths. Momentum investing has been the dominant trend this year, and many high profile value investors have struggled. Whilst we would never put ourselves singularly in the “value” camp, we are certainly price conscious when looking for investments suitable for the portfolio. In general, financial markets are still driven to pay over the odds (in our opinion) for short term certainty, leaving more difficult, recovery-type situations friendless. If we have outperformed our style biases this year, it is because there was a generally high level of earnings delivery in the portfolio. We expect that to continue into the new year.
If there is a dislocation between price and risk in equity markets, it is arguably even more acute in the fixed income space. The hunt for yield has now pushed the yield on Euro-denominated junk debt below that on US Treasuries. The Greek 10yr bond now yields less than 5%, despite the country still being heavily reliant financial support packages from third-party governments. Perhaps the most extreme manifestation has been in the leveraged loan market, where high yield issuance is up by 38% so far this year, and now has outstanding debt of $1.25trn. Nearly three quarters of this debt is on “covenant-lite” terms; offering virtually no protection to investors. 82% of issuance this year has been done on this basis.
Unfortunately, these trends echo from the last boom and bust; a lack of due diligence and financial discipline undoubtedly contributed to the subsequent crash. For me, one of the telling moments in the last crisis was a Fred Goodwin answer to a question about due diligence in the analysts’ meeting on the morning RBS announced its counterbid for ABN AMRO, gazumping Barclays and generating the perfect pyrrhic victory. When asked to describe the amount of due diligence RBS had done ahead of the bid, Mr Goodwin described the process as “due diligence-lite”. No one batted an eyelid.
Allegedly, Albert Einstein’s definition of insanity was doing the same thing time and again, but expecting a different outcome. A lot of history is repeating itself. It behoves us to make sure that we are aware of the consequent risks.
To our minds, the greatest of these risks is one of valuation. The risk of a more serious and painful descent into the kind of financial implosion that took place a decade ago is reduced as there is a whole lot less leverage across the financial system than there was a decade ago, particularly in retail banks which were driven to rapidly shrink balance sheets as wholesale funding collapsed. These systemic risks are significantly reduced. However, the consequences of the mis-pricing of risk can still be very painful. Many of the companies whose share prices that went “pop!” after the dot.com boom were strong operators in growth markets, but in many cases it took shareholders years to recover the value lost in a few short months. When balance sheet gearing is added to the mix, the destruction in value can be permanent.
If all of this suggests that we are quickly looking for the nearest cliff to jump off, then it shouldn’t. For whilst we feel that parts of the market are grossly overvalued, there are plenty pockets where the risk/reward sits much more firmly in the purchaser’s favour. Where an element of discretion is required is that none of these opportunities fall into the camp of “easy” investments. The flip side of investors overpaying for momentum is that recovery is deeply undervalued. However, recovery takes time and rarely happens in a straight line. Patience is required when the investment is made, and equally patience is frequently required before committing capital in the first place. Believing that unloved areas of the market offer fantastic opportunities for medium term capital gains (which we do), is not the same thing as saying we must buy in today. At our recent meeting, one of our resident Wise Men, Adrian Cunningham, reminded us of a quote from Rudiger Dornbusch;
“In economics, things take longer to happen than you think they will and then they happen faster than you thought they could.”
This perfectly sums up the investment dilemma today, and looking into next year. We see great investment opportunities when financial markets rotate out of their current trends. We, equally, fully recognise that these trends could run for a long while still. But when change comes, it is likely to happen quickly. Preparation is everything.
May we wish all of our friends in the investment community a very Merry Christmas, and thank our investors for their support once again this year. May we also offer everyone best wishes for the New Year ahead. With MiFID II coming on top of all the normal challenges, 2018 is unlikely to be dull.