Why You Should Ignore the Market

Rotman Professor Eric Kirzner interviews two of North America’s leading value investors about the current investing landscape, the efficiency of markets, and how some things — like human behaviour — never change.

Eric Kirzner: Many of us have been surprised by how well the market has responded to Donald Trump’s presidency thus far. How do you account for it?

Charles Brandes: What is so interesting to me is, all of the expert opinions and polls turned out to be wrong — and we should keep that in mind, as far as investing goes. Expert opinions are something you have to be very careful about. As we have seen over history, in many cases, they are worthless.

Whether people have been surprised by the results of Trump so far or not, the fact is, nobody really knows what effects his presidency will have on the market. Having said that, we do know a few things: Since 2008, value investing has not performed as well as it usually does in comparison to growthstock investing, and there are a couple of reasons for that. First, in periods of declining interest rates, the type of value stocks people buy are from industry categories that don’t do as well as growth stocks. Also, when you’re value investing, what you are buying is present earnings and present cash flows; and when you’re investing in growth stocks, you’re buying earnings potential in the future. So, if you discount that at a low interest rate, you could pay more for growth stocks than you would for value stocks when interest rates are low.

Now, it looks to me like interest rates are starting to reverse, and historically, in periods of rising interest rates, value stocks do quite well. That’s because rising interest rates usually mean that the economy is growing, and when economies grow, value stocks perform better. Historically, starting in the early 1970’s during a period of rising interest rates, our value stocks did quite well; and the same was true during the period of rising interest rates from 2002 to 2007. After that, as rates declined, value stocks didn’t do as well. Of course, there are many other factors involved, but we’re starting to see a ‘value premium’ that could last for quite some time.

Investing is as much about being an emotional human being interacting with the world as it is about underlying fundamentals.

Kim Shannon: From my perspective, I was certain that if Trump won, the markets would plunge, because it would create high levels of uncertainty — and we all know that the market hates uncertainty. So, it’s a really good thing that I’m a value manager, because we don’t bet on things like that. We are ‘bottom-up’ stock pickers. While we couldn’t have forecast what happened [when Trump was elected], we certainly didn’t make any changes to our portfolio because of it.

In terms of the impact Trump will have on markets, it’s really hard to tell, because we don’t know how much of his campaign platform will be implemented. For me, the main question is, What will he do with interest rates? They have been falling since 1981-82, and we’ve been waiting for a big paradigm pricing shift. Was July 2016 the bottom — and are we starting the march up? I’m a big proponent of ‘sideways market theory’: If that was the bottom in rates, then we are now in a neutral phase for equities; but I’m not at all certain that is true. I’d like to be able to make that judgment in a year or so.

The fact is, in terms of making money as a value manager, the economy and politics really don’t matter: Recent research from Montreal-based Bank Credit Analyst (BCA), using 112 years of data, found that only 17 per cent of stock market behaviour is influenced by the economy.

EK: Let’s move on to the theory of value investing. Some people believe that if a stock is trading at $30, that means it is worth $30. Is that true?

CB: You’re referring to Efficient Market Theory, and as a practitioner over the last 47 years, I can say that it is total and complete bunk. Over that period of time, I have seen market prices of companies fluctuate a heck of lot more than the actual basic intrinsic value of the company and the industry itself. That’s just a plain old simple observation.

EK: The emerging field of Behavioural Finance shows that people make investment decisions based on pervasive psychological biases. What are some of the key biases you see?

CB: Many of these biases are built into us due to our evolution, because early on, it was really important for humans to think short term — or we would not have survived to see the next day. The problem is, as far as investing goes, that is the wrong way to think.

Another bias I often see is a very strong herding instinct: We like to be grouped together and aligned with everybody else. But if you want to be an outstanding investor, you can’t do what everybody else is doing. I also see a lot of extrapolation: Right now, everyone sees the U.S. market doing quite well, so they extrapolate that it will continue to do well. That could be a big mistake.

EK: How can we avoid some of these biases?

KS: One of the advantages of being a value manager is that it automatically puts you in a contrarian mindset. It causes you to go against the crowd, and as Charles indicates, it’s much easier for people to go along with what everyone else is doing. Academic studies continually show that value investing works, so you would expect more investors to be involved in it — but in actual fact, there are very few disciplined value managers out there — in part because of the herding instinct.

For example, look at the ownership of Valeant in Canada in the last year and a half: If you were willing to really look at the financial statements and dig below the surface, you could see a lot of troubling elements in this firm — and yet it got as high as 6.2 per cent of the TSX. For a period of time, our clients were okay with us saying, ‘Valeant is clearly not a value stock’, and we could move on; but by last summer, we were getting lots of questions: ‘Explain to us, in gory detail, why you don’t own Valeant — because we think it’s hurting our returns’. It finally collapsed in the fall of 2015.

This type of client input is par for the course for us. Recently, we’ve been getting grief over our renewed love for Empire Company (Sobey’s) and last year, Charles, you were talking with great enthusiasm about Russia — when no one wanted to hear about it. To succeed in this field, you really have to be comfortable being a contrarian.

EK: One of the key principles of value investing is the notion of finding companies — in many cases, great ones—whose shares appear to be selling at significant discounts to their intrinsic value. Why does this happen to a company?

KS: There are numerous reasons, but being overlooked, under-followed and/or in some kind of trouble is how I usually think of them. Often, a management team will stumble in some way — which is what happened at Empire: They made an acquisition that should have been terrific, taking them from being mostly regional to national. It should have been an easy integration, but it wasn’t; then they misstepped and fired their CEO. This created an opportunity to buy a good-quality firm without much debt. If you believe that the company can figure out how to get back in the saddle, that is an opportunity for significant returns in the long-run.

CB: As Kim indicates, there are a lot of reasons why a company might be under-valued. During the tech bubble of 1999-2000, everyone believed that, if you didn’t own technology stocks, you were ‘out of it’. I remember clients calling me and saying, ‘You are finished as an investment manager, because you don’t own any of this up-and-coming internet stuff.’ And, we didn’t—because they were outrageously expensive.

Then, suddenly there was so much money going into that area that the basic fundamental companies were not attracting investment. Even though they were actually doing well, their stock prices weren’t going up, so there was an unbelievable amount of value there. That’s one example of how you can find under-valued companies.

Other reasons can be cyclical movements, or as Kim indicates, short-term problems. If you do a deep analysis of a company that is in trouble, sometimes you can see that the problem is not going to last forever. For example, Volkswagon during its emissions crisis, and BP during the oil-spill debacle. These were horrible, but temporary, situations for really good companies—and that can provide an opportunity to buy them below their actual value.

EK: How do you get started on developing a working list of companies that might fit into the value class?

KS: Today, information is so easy and cheap to obtain. Back in the day, I used to have to pluck numbers off of financial statements and enter them into a computer system; but with today’s tools, we can basically grind through all of the publicly-listed stocks in the marketplace. At my firm, we focus in on a formula that relies on classic value ratios like price of sales, price of cash flow and dividend yield, and we come up with an intrinsic value; then, we rank the entire universe according to ‘cheapness’.

Every sector of the market is ‘open season’ for a value investor — but not always at the same time, because at any point in time, a stock can stumble. The easy part is finding something that is cheap; then you have to do the deep analysis to find out whether it is truly a value candidate. Does it have the appropriate risk characteristics? A lot of times it’s a question of, ‘Can this stock truly revert back to its mean?’

CB: We use the same criterion, as far as starting with low-priced or ‘unusually-priced’ shares. Then we look at balance sheets, dividend yield — all of that. We have analysts divided into eight different industry groups, headed up by 25 senior people. They are responsible for understanding their industry group and which companies within it might be potential investments for us. Of course, we will always be attracted to the worst-performing market in the world, and we’ll take the time to examine what’s going on there. We don’t find much anymore in the world’s best-performing markets.

EK: A few years ago, Charles, you talked about Microsoft as a prime example of great value. Do you still believe this?

CB: A few years back, the Cloud was launched, and suddenly, Microsoft was considered old-fashioned. They didn’t own the software market anymore, and PCS were disappearing. As a result, one of the premier growth companies in the world got down to about 10 times earnings — which is the cheapest it had ever been. We looked at it and said, ‘Wait a minute. Maybe this overall impression that the PC market is going away is incorrect; Microsoft’s size still gives it a huge advantage, and its leaders will probably figure out how to keep up with the Cloud and other developments.’ At the time, Microsoft was $20 to $30 per share, so we bought it because we believed it had a future. Today, it’s around $60 a share — so we would be looking elsewhere for deeper discounts.

Every sector of the market is ‘open season’ for a value investor — but not always at the same time.

EK: Charles, back in 1987—after the largest single-day loss in market history, Black Monday—you were asked on national television, what you would be doing differently as a result. Your now-famous answer: ‘Nothing’. Please explain.

CB: That’s a typical mistake investors make: They get really concerned about short-term stock market price movement and think it’s going to continue forever. It happens all the time. I get clients asking me ‘When the market’s going down, what should I do?’ And, of course, the first part of my answer is, ‘Do nothing’, because the market does come back, and if you like what you have in your portfolio, you should leave it alone. Never try to out-guess the market. Of course, an even better answer to that question is, ‘Buy more if prices are down’ — but over many years, we’ve found that our clients have difficulty doing that.

KS: I absolutely agree with Charles: If you have a robust portfolio, you should never move it around on a day like that, but you can look around for other opportunities. For me, as a value manager, one of the best times to do that was, sadly, in the aftermath of 9/11. Canadian markets reopened on the Thursday or Friday, but the U.S. didn’t reopen until the following Monday. After the tragedy, every stock in the market was down by 20 or 30 per cent. Enormous bargains were available all over the floor—but you had to realize that your portfolio was also down 20 to 30 per cent. It was easy at that moment in time for an active manger to be shell-shocked — and I certainly was.

Investing is as much about being an emotional human being interacting with the world as it is about underlying fundamentals. The beauty of having some extra time that week was that I could come to work on Monday and say, ‘Wait a minute: We’re all upset, but rationally, this is one of the best buying opportunities of my career. I have to act.’ It’s very tough to step in after big drops like that, but value managers have been trained to do the opposite of what most people are doing.

CB: The stock market really has nothing to do with true investing. Most of the time, you should be totally ignoring the market and stock price movements and volatility. Instead, you should be looking at the companies you own, and how they are doing over a long period of time. That has nothing to do with stock market fluctuations.

EK: Charles, your firm has been investing in emerging markets since 1982. You were among the first to start pursuing that area. How do you go about distinguishing opportunities in emerging markets?

CB: Terms like ‘emerging market’ and ‘developed market’ aren’t what investors should focus on. Instead, they should be looking at individual markets and individual companies within them. Where they are based is less important. As Kim indicated earlier, this is a bottom-up-type of thinking — rather than a top-down approach that puts all emerging markets into the same bucket.

The fact is, each emerging market is different: Brazil is very different from Russia, which is very different from South Korea. What is not that different is how businesses operate around the world. As always, the main thing we take into account is, how a company is priced today in the public market, compared to its long-term intrinsic value.

In building our portfolio, we look all around the world, including emerging markets and developed markets—even at so-called ‘frontier markets’, trying to find the largest margin of safety, no matter where the company happens to be located. Emerging markets had been doing very poorly until about June of 2016, but they’ve done extremely well since then. Because they were doing so poorly for so long, people got scared and

lots of money was coming out of them, and suddenly they were very, very cheap.

We find certain markets are a lot better than others: We still think Brazil and South Korea are very interesting; and we find Russia and some of its major companies interesting. You have to discriminate between companies, from a bottomup standpoint, rather than just looking at ‘emerging markets’ in general.

EK: How do you avoid the ‘gambler’s ruin’ risk—of being right about a country, but wrong about individual selections?

CB: Our whole job is to try to understand the fundamental risks involved with each company and industry, the changes happening in management, the balance of the company and its historic rates of return on equity. We look at these factors to try to determine whether, in actuality, the intrinsic value we come up with is fairly close to the company’s long-term value. Our whole job is to make that determination. Of course, sometimes we’re wrong; but that’s why it’s so important to have a diversified portfolio.

Some investors rely on indexes, like the Morgan Stanley Capital International Emerging Markets Index (MSCI Em)—but they are very biased from the standpoint of market capitalization: You are only able to buy the four or five biggest companies in a country like China, India or Russia — which is extremely limiting with respect to the actual potential of companies in these markets.

EK: Value investing has its roots in the 1930s, when it was called Fundamental Analysis, and over the years it has enjoyed a 2.5 to three per cent advantage over growth indexes. Do you believe that it is as relevant today as it always has been?

CB: Yes, because it is based upon economics and wealth creation over a long period of time in a free enterprise economy. Looking back to when Ben Graham started on Wall Street in 1914, there has been lots of change in terms of information availability, but not much difference in the cyclicality of businesses and the way wealth is produced over a long period of time. And there has been little to no difference in human behaviour.

Charles Brandes is the founder and Chairman of Brandes Investment Partners, L.P., and a member of the firm’s Investment Oversight Committee. He is the author of Brandes on Value: The Independent Investor (Mcgraw-hill Education, 2014). One of the most closely followed value investors working today, he is a disciple of the Benjamin Graham school of value investing. Kim

Shannon (Rotman MBA ‘93) founded Sionna Investment Managers in 2002. She was previously Chief Investment Officer and Senior Vice President at Merrill Lynch Investment Managers Canada Inc. She is a past president of the CFA Society of Toronto. Eric Kirzner is the John H. Watson Chair in Value Investing and Professor of Finance at the Rotman School of Management.

This interview took place at the Rotman School of Management on January 12, 2017.