New art and science of investing in largely uncharted waters
| A changing world means investors have had to adapt
FUND managers have had to navigate a number of market cycles, often influenced by macro events, in the past few decades. There was the oil crisis, the decline in the gold price, sanctions, various interest rate hikes and falls, globalisation, emerging market jitters, the 2008 financial crisis, and a drop in commodity prices, among others.
It could be argued that these crises and market cycles all have important lessons for investors — lessons which can be applied to lessen their risk of underperforming. But is that really the case?
Conventional wisdom no longer always holds true, argues Peter Linley, manager of the Old Mutual Investors Fund. “We’re in largely uncharted waters much of the time because the issues we’re facing today are so different.” The world has changed dramatically in the past 50 years, which has meant that the way fund managers invest has also had to change, points out Sandy McGregor, a portfolio manager at Allan Gray.
“Macro events and politics play a much larger role in the market than they did historically. In South Africa we’ve gone from apartheid to democracy, while globally the world has gone through a period of unprecedented change — and with change comes new ways of investing.”
The rules of investing, McGregor adds, have changed significantly since the 2008 financial crisis. Banks in particular are much more regulated globally than they were prior to the crisis.
“Over the past 50 years, monetary theory has replaced Keynesian theory about how governments should act to achieve economic stability,” explains Guy Toms, head of fixed interest at Prescient Investment Management. “Traditionally, central banks responded to periods of excess demand by raising interest rates — and reducing interest rates when demand fell away.”
But they were behind the curve in terms of curbing excess demand between 1999 and 2008, with the result that the amount of debt in the financial system exploded. “We are now living in a world of massive leverage and debt, and demand is not rising. Economies are not responding in the traditional way to changing monetary policy,” Toms says.
Fund management, adds Linley, is both an art and a science. Markets reflect a large dose of investor sentiment in the short term, driven as they are by individuals and their emotions.
“Human behaviour has a significant influence on the market. If what we did was entirely a science, then a computer could do it.”
However, markets are also extremely sensitive to macro events, and issues such as a push on monetary policy, quantitative easing, high debt levels and lower investor confidence — to name but a few — all have an impact. In spite of this, experienced fund managers have learnt to adopt a measured response to market cycles.
“Nenegate may have caused bank shares to lose significant value on December 9 2015, but it would have been a mistake to sell bank shares when their prices collapsed after that announcement,” says Linley.
“Currently, many investors are concerned about the impact a possible sovereign ratings downgrade would have on the economy. But what is interesting is to consider what happened to bank shares in Brazil post a ratings downgrade. These shares underperformed up until the time of the downgrade, but post the downgrade they rallied and started to outperform. There is no doubt that South African banking shares will be hit in the event of a downgrade, but they remain attractive on a longerterm view.”
History, it appears, does offer some lessons. Banks, points out Linley, are trading close to their “bear scenario” valuations — which assumes a sovereign downgrade and its associated negative impact on earnings.
Despite the unique current global economic challenges, navigating market cycles and volatility are a reality and nothing new, says Linley. “Markets today are no more difficult today than they have ever been. There is an inherent challenge to them — they’re difficult, period.”
Charlie Munger, vice-chairman of Berkshire Hathaway, famously said of investing: “It’s not supposed to be easy. Anyone who finds it easy is stupid.”
It takes many cycles — and many years — to judge a really good fund manager or fund management team, maintains Linley. “The real test is to evaluate a fund manager’s success over at least a 10-year period. Practically, that’s difficult because not many sustain for that long.”
Legg Mason Capital Management’s Bill Miller was one fund manager who did go the distance. He managed the Legg Mason Value Trust, which consistently beat the S&P 500 index for 15 consecutive years from 1991 to 2005. In spite of this phenomenal achievement, some critics have suggested that luck could still not be ruled out of his success.
Miller himself has been quoted as saying that this achievement was an “accident of the calendar. If the year ended on different months it wouldn’t be there and at some point the mathematics will hit us. We’ve been lucky. Well, maybe it’s not 100% luck — maybe 95% luck.”
Successful fund managers, says Linley, tend to have a clear and sensible investment philosophy. They focus more on the decision-making process than the short-term outcome and critically evaluate the success or failure of their investment decisions. Another trait is that they actively try and assess the market in a different way to everybody else.
They don’t look for the obvious or the first level of easy and simple. Instead, they adopt what US investor and author Howard Marks calls second-level thinking, which questions conventional wisdom and personal assumptions and then evaluates all possible scenarios and outcomes.
“This is a tough industry in which to perform and being smart is not enough,” says Linley.
“For fund managers to succeed, they need to have an efficient and effective process. Volatile markets are a reality and successful fund managers can’t afford to make emotional decisions focused on the short term. Having a sensible philosophy and strong process in place takes the emotion out of the investment decision.”
For the Old Mutual Investors Fund, this process involves a regular assessment of all investment decisions. “In order to keep learning, you need to ensure strong record-keeping and then carefully analyse each decision. It’s a process which allows us to navigate market cycles over the long term and to keep delivering superior returns through the cycles.”
The secret to beating the market,
❛ His first experience of a market crisis was nerve-racking, but he’s learnt to navigate them ❛ This is a tough industry in which to perform and being smart is not enough
he adds, is to look beyond the obvious and to double-check valuations. “We acknowledge that there is a high level of subjectivity in estimating intrinsic value, which is why we calculate a base, bear and bull scenario for each share and assign a probability for each. The bear scenario helps us understand possible capital loss in our clients’ portfolios, while the bull case enhances our understanding of the potential upside relative to our base case,” he says.
McGregor admits that his first experience of a market crisis — in the ’70s — was nerve-racking, but having been through a number of these during his career, he’s learnt to navigate them more calmly. “No investor or fund manager gets it right all the time — despite what you may have been led to believe,” he insists.
“Timing is critical and one of the biggest challenges we face currently, particularly now that the market is more concentrated than ever before, is the risk of selling too soon or, conversely, too late.”
Market volatility and market cycles can present opportunities for investors, points out Linley. “What I’ve learnt as a result of the many notable events we’ve had to navigate in recent years is that markets do recover. As an investor, you need to be wary of being sucked into the emotion of the events and, instead, look out for opportunities.”