Investing in stocks and shares requires optimism about the future. A fund managers role, as an investor, is to endeavour to discount the future cash flows of companies in which they invest. The overarching concern is to distinguish between those businesses which will survive and thrive and those which will struggle and in time become shadows of their former selves. Think Polly Peck, Ratners, Carillon, House of Fraser, Barings Bank, Equitable Life to name but a few corporate disasters in recent years.
Looking myopically at a price multiple of today’s earnings is not enough. In fact, quite the opposite, it can be positively misleading. Fund managers need to be forecasters without being soothsayers.
Just as importantly, they need to be able to spot where markets are over-anticipating future growth—where valuations indicate “irrational exuberance”. This is as much an art as it is a science and, to borrow an expression, it is better to be roughly right than precisely wrong.
It is often more useful to look for clues in corporate track records than to rely on spreadsheets which project future earnings. Analysts have a tendency to obsess over the exactness of long-term forecasting when it is hard enough to pinpoint accurately the next quarter or two. That explains why some managers, favoured by Clarion, prefer more predictable businesses where there is less scope for forecasting error.
Bill Gates of Microsoft famously said “We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten. Don’t let yourself be lulled into inaction”. Words that are helpful to any long-term investor seeking to avoid traps or seize opportunities but it is ironic that Microsoft’s Excel spreadsheet has done so much to both help and hinder the investment industry by facilitating an over reliance on exact forecasts. Given a low enough discount rate and a high growth trajectory, any valuation can easily be “justified”.
The obsession with spread sheet forecasting of future earnings also provides a clue as to the reasons behind the recent panic in world stock markets. In a few weeks, Wall Street, by way of example, has swung from a record peak into correction territory, defined as a drop of 10% or more. It is not hard to find a number of possible reasons why the once seemingly impervious US share market is falling into line with the less than stellar showing by equities elsewhere.
Higher Bond yields, and therefore a higher discount rate in valuing future earnings leading to lower valuations, are getting some of the blame. Then there is mounting evidence of how China-US trade friction, a stronger dollar, and slightly weaker global growth are hurting US Companies. But really the main reason for recent falls in equity prices is the sudden change in sentiment from optimism to pessimism and the fact that some fund managers chase glamour, flavour of the day stocks without having regard to the sustainability of company earnings. A sudden change in the discounting rate, and sentiment, and the number crunchers press the sell button.
At times of stock market panic the prices of good companies fall along with the prices of bad companies. The shares in good companies are generally more liquid and are often easier to sell at times of market stress and so fall further but recover more quickly when the clouds clear. On the other hand some share prices may never recover to recent highs.
If we could draw up a wish list of positive outcomes, Investors would like to see more stimulus from an already heavily indebted China and a resolution over trade with the US. Add in a budget agreement between Italy and Brussels, and a Brexit deal and any sign that the Federal Reserve may hold back on future interest rate rises, thereby undercutting the US dollar, would be icing on the Investors risk cake. Any or all of these could happen in the coming months and confidence would then be restored and markets would recover lost ground and possibly even go to new highs.
Equally there has been a fundamental change in Investors perception of the future. Quantitative Easing is now turning to Quantitative Tightening. Inflationary pressures are building, interest rates and bond yields are now rising. Globalisation is being reined in by trade wars. These trends translate into a fall in bond prices but may be good for the equity valuations of good companies when sentiment improves but it also means that traditional cautious investment portfolios are no longer cautious because the safety net of the fixed interest components is susceptible to rising interest rates.
As often happens at times of fundamental change, financial markets become more volatile until new trends are established and become clearer. From here on in investment returns will become much more challenging than in recent years when the liquidity rush of Quantitative Easing and low interest rates fed through into rising share prices of both good and bad companies. We are in the first stage of a period where share prices will experience higher levels of volatility but that should be good for active managers and stock pickers of the type favoured by Clarion. It is less cheery news for autopilot strategies using exchange traded funds.
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