Reprinted courtesy of the National Post
by Tom Bradley
I admit it. I’m a New England Patriots fan. This admission may seem trivial, but I live on the West Coast where the Seahawks are worshiped.
I take the reputational risk because of how the team is managed and coached. Yes, five Super Bowls feeds my fandom, but I like the fact that the team is in the hunt every year despite never having a high draft choice and rarely paying up for free agents. The Patriots draft like a value investor and coach Bill Belichick is the master of making the best of what he’s got.
Investment managers also need to play to their strengths. Their game plan is to buy mis-priced stocks based on their fundamental outlook (future profits) and/or valuation (price-to-earnings ratio). That sounds easy enough but renowned industry thinker Charlie Ellis reminds us, “the worldwide increase in the number of highly trained professionals, all working intensely to achieve any competitive advantage, has been phenomenal.” In other words, there’s lots of smart people trying to do the same thing.But like the Patriots, portfolio managers do have edges they can exploit. I’ll use the current market landscape to illustrate three — flexibility, time frame and valuation.
Managers’ toughest competitors are index funds. They never want to meet an indexer in the first round of the playoffs. But for managers who are truly active (not just hugging the index) and have a longer time horizon, the trend toward indexing is an opportunity.
I say that because most indexes are valuation insensitive. Their makeup is proportional to the size of companies, not their P/E ratios. As a result, it’s often the case that companies and sectors are most expensive when they’re at their biggest weighting. Gold and energy were important components of the S&P/TSX Composite Index when they were flying high, as were stocks like Nortel and Valeant.
And yet, valuation is the most reliable predictor of future returns which is why active managers should celebrate the growth of index funds. The more money that’s valuation-insensitive the better.
Watching CNBC on a day when markets are soaring or plummeting is better than an episode of Bodyguard. It’s electric. Big price moves. Commentators jumping out of their skin. It’s easy to get sucked into the drama.
But these types of shows shouldn’t be confused with long-term investing. They’re focused on the news of the day. There’s no discussion about diversification or portfolio construction, and little said about valuation.
A successful London manager told me recently that he makes most of his money in the U.S. companies that are media darlings. That’s because these stocks bounce around with the news cycle even though the companies’ fundamentals are quite stable.
Our instant gratification world is a gift for investors who have a good sense of valuation and are willing to be contrarian.
I’m not much for macro-based investment strategies. Not only do they require an accurate economic call, but it’s also necessary to predict how stock prices will react if the call proves correct. Both are hard to do.
There are economic and political events, however, that have already occurred and result in unusual stock movements. I’m referring to structural dislocations caused by pension, insurance and banking legislation, fiscal and banking crises, commodity booms and busts, and of course, trade policy.
Today, the world is full of dislocations. The uncertainty around Brexit has put a pall over U.K. stocks. The Asian markets have been crushed by trade tensions and rising U.S. interest rates. And in Canada, transportation issues have hit the oil and gas producers.
Geo-political disruptions can permanently impair a security’s value, but in most cases companies adjust to the new set of rules and the speculation is worse than the reality. Investors who can look further out and buy with clouds overhead are often rewarded.
Asset managers can’t contend for the Super Bowl every year like the Patriots do. Bad years are necessary to set up the good. But the odds of success go up when they care about the price paid, ignore the indexes and, importantly, develop a client base that allows them to take a longer view than the experts on TV.
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