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Valuing the Future

28112018_pendulum swings

Valuing the Future

Buy low and sell high, the adage goes. While equity markets might be expected to deliver a healthy average return over time, history shows that the performance of the market in any given year is likely to vary materially from this average. In other words, there should be plenty of opportunities to buy low and sell high. But is investing so easy?

In reading Mastering the Market Cycle, the new book by Howard Marks (Chairman and Co-Founder of Oaktree Capital) I came across a passage that looks at the variation in stock market returns in any given year.

Over the period of 1970 to 2016, the annual returns of the S&P 500 have fluctuated between plus 37 per cent and minus 37 per cent. While the long-term equity market return is usually stated as 10 per cent or so, Marks asks readers the following question: for how many of the 47 years from 1970 through 2016 was the annual return of the S&P 500 within 2 per cent of “normal.” In other words, between 8 per cent and 12 per cent?

The answer is rather surprising. Over that period, the S&P 500 delivered annual returns within that 8 to 12 per cent range only three times.

The corollary of this is that the market can swing wildly beyond the average return in any given year, and it is this variability in stock market returns that allows shrewd investors to generate outsized investment returns.

The premise of value investing

Value investing is that you buy an asset for less than it is worth, and you then make money by this value gap closing. This diminution of the value gap is critical; the absence of this leads to what are called “value traps,” where a stock will on the surface look cheap, but for any number of reasons will remain “undervalued” for a protracted period.

In his book, Marks highlights the importance in understanding cycles and their pendulum-like nature, given that investors can exploit the vagaries of the market to take advantage of stocks when they become undervalued. He cites his second memo to clients that he wrote back in April 1991, and the description he gives of how market cycles operate is pithy, vivid, and worth reproducing in full:

“The mood swings of the securities markets resemble the movement of a pendulum. Although the midpoint of its arc best describes the location of the pendulum “on average,” it actually spends very little of its time there. Instead, it is almost always swinging toward or away from the extremes of its arc. But whenever the pendulum is near either extreme, it is inevitable that it will move back toward the midpoint sooner or later. In fact, it is the movement toward the extreme itself that supplies the energy for the swing back… This oscillation is one of the most dependable features of the investment world, and investor psychology seems to spend much more time at the extremes than it does at the “happy medium.” 

Investor behaviours

While investing might appear simple, one cannot overstate the powerful effects that the psychological biases we all harbour can have at either extreme of the market cycle. Marks frames this when he observes investors’ predisposition to flit between credence and scepticism: “This cycle in investors’ willingness to value the future is one of the most powerful that exists.” Marks goes on to elucidate this concept:

“A simple metaphor relating to real estate helped me to understand this phenomenon: What’s an empty building worth? An empty building (a) has a replacement value, of course, but it (b) throws off no revenues and (c) costs money to own, in the form of taxes, insurance, minimum maintenance, interest payments, and opportunity costs. In other words, it’s a cash drain. When investors are in a pessimistic mood and can’t see more than a few years out, they can only think about the negative cash flows and are unable to imagine a time when the building will be rented and profitable. But when the mood turns up and interest in future potential runs high, investors envision it full of tenants, throwing off vast amounts of cash, and thus salable at a fancy price.

Changing sentiment

We have recently seen an example of investor sentiment sharply changing when looking at Facebook (Nasdaq: FB). Due to a slate of negative publicity around the role of the Facebook platform in U.S. election meddling, as well as various user privacy missteps, the stock has been beaten down badly by the market. At these price levels, Facebook is akin to the empty building, where the market is unable to see the business turn the corner and “rent out the building” so to speak. The market is also ignoring the many revenue opportunities that may develop outside of the company’s existing business. I will give an example of this.

The global team recently had a call with an industry contact in the digital advertising industry, discussing Facebook specifically. An interesting part of the discussion revolved around the potential to monetise messaging apps, namely Whatsapp and Messenger, via chat bots. Longer term, Facebook has an opportunity to develop chat bot AI capabilities to such an extent that they are capable of replacing the sales forces of organisations.

Imagine this, a world where chat bots in Whatsapp or Messenger are able to drive sales like a human sales force can. While this might never eventuate, there’s a chance that this could generate material value for Facebook, which arguably is not being priced in today.

In other words, in addition to investors ignoring Facebook’s ability to recover from its current malaise, they are also ignoring these long shot ventures that Facebook is spending money on which might generate new monetisation opportunities, and material shareholder value. The company is deeply out of favour, and much of this results from investors no longer being willing to give Facebook credit for the value it might create in the future.

While the market will periodically swing to a mood of negativity and pessimism, as it has in the case of Facebook, we are of the view that much as the pendulum will inevitably retrace its arc, investor sentiment towards Facebook will at some point swing the other way.

The Montgomery Global Funds and Montaka own shares in Facebook. This article was prepared 27 November with the information we have today, and our view may change. It does not constitute formal advice or professional investment advice. If you wish to trade Facebook you should seek financial advice.


George joined MGIM in September 2015 as a Research Analyst. Prior to joining MGIM, George was an investment analyst at Private Portfolio Managers where he covered global equities across various industries, using a value investing framework. George’s prior experiences include equities research and investment banking roles at both Citi and Greenhill & Co.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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  1. I embrace the idea of value investing. However, there are always complications, no matter what investment strategy you apply. The basis of value investing says to seek out companies where the current share price is below the intrinsic value. Then providing many other factors are in place, e.g. high ROE, good prospects for growth, etc. you should invest.

    A dilemma I have is this. What happens if you find a share that stays overvalued for a long time? I’m sure you can go back in history and find an example of a share that fits this description, and it still turned out to be a brilliant investment even if bought at a point when it was overvalued. I think it is too easy to say, OK, even with a good strategy you will miss some opportunities.

    I have not seen any discussion about this dilemma in value investing and I think it warrants it. How do we deal with this situation? My view is we should not simply rule out shares that are overvalued. We should allow a margin of error. Even the most skilled people at valuing companies get it wrong. It is never an exact science because five independent analysts, say, will probably come up with different valuations.

  2. Thank you for the article.

    In addition to fundamental valuation of entities, this article mentions that you can take advantage of ‘psychological behaviour in order to fine tune buying lower or selling higher.

    Apart from Howard Marks’ book, can you also recommend ‘modern’ contemporary reading which combines the sciences of psychology and economics. Not necessarily the 1841 book “Extraordinary Delusions….” but something more contemporaneous.

    Thank you,
    Anthony of exciting Belfield

  3. Facebook has still had a pretty big run George. Under 20x seems interesting though, when you see some of the no growth stocks in the US at the same multiple.

    I think what makes buying low and selling high so hard is the patience required. If prices are high, you may to wait several years for the prices you are craving. And there is a good chance you will be watching others getting rich during these times- not many people can stick it out. Personally I have been somewhat defensive and slowly building cash for 3 or 4 years now with underperformance to show for it. Definitely too early, but if you are fully invested at the top, there is nothing to buy low with.

    I know this seems fairly obvious, but that isthe elegance of Marks’ memoes- stating the obvious in a way that makes you rexamine your process.

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