We live in a volatile world characterised by a bombardment of data. Economic releases and market updates are continuously being streamed to our TVs, PCs, tablets and even to our cars, smartphones and smart watches. We seem to move from one crisis to the next, some of which are potentially so severe they threaten to demolish the financial world as we know it. Most of it is just noise, exacerbating market volatility (see Fig. 1).
At Argon Asset Management, we think volatility is here to stay. This creates opportunities for disciplined long-term investors, and particularly for bottom-up stock pickers.
Bottom-up stock pickers generally base investment decisions on their estimation of the intrinsic value of a share. They focus on the fundamentals of the underlying company, industry dynamics, cash flows and so on in order to arrive at a fair value – or intrinsic value – for the company. Share prices (what the market is willing to buy or sell the share at) tend to fluctuate around the intrinsic value of shares, with the market swinging between overvaluing shares (when share prices trade above their intrinsic values) and undervaluing shares (when share prices trade below their intrinsic values). Volatility tends to exaggerate the mispricing (over and undervaluation) of securities. This creates opportunities for bottom-up stock pickers, as share prices tend to deviate further away from their intrinsic values, and more frequently.
Beating the market
According to the efficient market hypothesis, it is impossible to ‘beat the market’ because stock market efficiency causes existing share prices to reflect all relevant information. But surely the fundamental long-term intrinsic values of proper businesses cannot change as frequently as market volatility suggests? This invalidates the efficient market hypothesis.
Some new information may temporarily impair or improve the outlook for a company or industry, but well-run companies with long-term sustainable competitive advantages have proven track records of surviving tough economic down cycles. They continue to reinvent themselves over the long term. These temporary changes, therefore, should not significantly affect their intrinsic values. Volatility often results in great businesses being undervalued, creating attractive long-term investment opportunities for the patient, disciplined investor.
Well-run companies with long-term sustainable competitive advantages have proven track records of surviving tough economic down cycles
Since the global financial crisis, central banks around the world have implemented unprecedented accommodative monetary policy tools, such as quantitative easing and negative interest rates. Time will tell whether these unconventional monetary policy tools (or as the cynics would refer to them, ‘experiments’) are effective or not, as it is currently unclear whether they will merely cause unforeseen consequences and their own set of problems.
What is clear, however, is that these unconventional monetary policy tools have resulted in unconventional market distortions and increased volatility. The US ended its quantitative easing programme and has attempted to ‘normalise’ monetary policy, which has resulted in an increase in market volatility. Uncertainty about the timing of interest rate hikes and its effects continue to sway markets.
The environment of low interest rates has created a search for yield, which has distorted sector valuations as investors have been prepared to pay up for stocks with bond-like characteristics, which are defensive and pay stable dividends.
This effect can be seen by the inflated valuations among global consumer staples, which trade at significant premiums relative to their histories. At the other end of this spectrum, global financials appear to trade at significant discounts to their respective histories. Adopting a passive investment strategy would result in counterintuitive behaviour, given the divergent valuations among sectors. Investors would effectively be buying high and selling low, in that they would be buying the index with relatively larger weights in expensive sectors, while being relatively underweight in the more attractively valued sectors.
Divergence among sector valuations is a common theme in markets, usually exaggerated at the peaks and troughs of cycles. During the Chinese economic boom, as China’s ferocious appetite for commodities elevated prices, resources stocks traded at significant premiums, while during the IT boom, tech stocks traded at excessive valuations. In the more recent past, investors have been willing to pay up for consumer staples stocks. Financials, on the other hand, have fallen out of favour since the financial crisis, and trade at cheap valuations relative to their history.
It is understandable that an enhanced perception of risk in financials should result in cheaper valuations, but the banks in particular are much stronger and better capitalised than they were prior to the financial crisis. Insurers have also proved to be more resilient than expected. These are all factors that belie the current valuations.
The bottom line is that sectors tend to move in and out of favour, as reflected by their valuations. Simple passive investing would not protect investors from irrational ‘cyclical’ peaks in valuations. Investors would be relatively overexposed to overvalued sectors, given their relatively larger weights in indices at their peaks, while being relatively underexposed to undervalued sectors given their relatively smaller weights at cyclical troughs.
Another benefit of bottom-up stock picking is that stock pickers are able to sift through the market and screen for mispriced securities. This allows bottom-up stock pickers to identify mispriced securities within broad sectors. In other words, bottom-up stock pickers may be able to identify attractive, relatively undervalued companies within expensive sectors or markets. Passive investment strategies would not (by definition) be able to identify these undervalued gems.
Opportunities to outperform
Another effect of the great quantitative easing experiment has been the excess global liquidity that has propped up global markets. The current bull market, which began in March 2009, is the second longest going back to data from 1929. The average bull market has lasted 32 months: as of April 2016, we are 87 months into the current bull market. This does not necessarily mean the bull market should end, or that we will enter a bear market any time soon. However, given the stellar market returns for the better part of the last decade, it would be unrealistic to expect similar returns over the next few years.
Given that the returns of the current bull market were supercharged by the tailwind of unprecedented monetary stimulus and liquidity injection, it would be fair to assume that we can expect lower returns over the next few years. Passive investing during strong bull markets may yield great returns driven by the rising tide of the market. However, during periods of lower overall market returns, stock picking should yield superior results to passive investing.
Algorithm-based and passive investing products have become increasingly popular. This applies to simple market capitalisation-weighted passive index tracking products like exchange-traded funds, and the more complicated ones that enable investors to access specific sources of risk and return (‘smart beta’ products). The growth of these investment products has seen the proportion of fundamental investor participants in the market decline, resulting in relatively fewer fundamental investors ‘pricing’ news into stocks. This is expected to result in an increase in mispriced securities, which we anticipate would provide more opportunities for bottom-up stock picking.
The rise of online trading software, day trading and algorithmic trading programs has resulted in increased volatility and shorter investor holding periods. Many investors claiming to be long-term investors in reality have shorter investment horizons than traditional long-term investors. This creates more opportunities for disciplined, true long-term investors who are willing to look beyond the short-term noise.