The ‘magazine cover indicator’ is one of the financial world’s more amusing contra-indicators. As the theory goes, by the time a trend makes it onto the cover page, that trend is about to reverse. (It works best for generalist, non-investment-specific media.)
In 1979, Businessweek published its infamous “The death of equities” cover. That pretty much marked the low point in the fortunes of US stocks – shortly after, a multi-decade bull run was underway.
In March 1999, The Economist ran with a cover story entitled “Drowning in oil”. The price of Brent crude was hovering at around $10 a barrel. That article pretty much marked the bottom. Within a year, the oil price had tripled.
In August 2000, meanwhile, Fortune published a piece entitled “Ten stocks to last the decade”. By that point, the bloom had already come off the dotcom rose. Nevertheless, Fortune’s list was replete with technology, media and telecom stocks: Nokia, Nortel Networks, Oracle and Broadcom all featured.
By December 2012, the Fortune portfolio had lost 65% of its value. Three of its recommendations had gone bankrupt – one had been bailed out. Warren Buffett defined the problem nicely: it is difficult to buy what is popular and do well.
One consequence of quantitative easing (QE) is that, by driving interest rates towards zero, central banks have driven investors into the stockmarket. And not just towards any old stocks.
In the absence of attractive yields from bank deposits or investment-grade bond markets, investors have stampeded into higher-yielding stocks – particularly global mega-caps, household names with extensive global franchises and a decent dividend yield. We’re talking about the likes of Coca-Cola, Johnson & Johnson, Unilever and so forth, which operate internationally and are widely considered “safe”.
The problem is that these franchise stocks now tend to trade at very high price/earnings (p/e) ratios and at multiples of their underlying book value. Coke, for example, trades on a p/e of roughly 20 and a price/book ratio of almost six.
We have been here before. Global pharmaceuticals stocks enjoyed comparable popularity in the run-up to 2000. The sector then de-rated hugely, and fortunes were lost. More recently, investors flooded into financials, only to have the credit crisis of 2008 smack them in the face. The financial sector has yet to recover. Human nature never really changes. In the words of Lord Overstone, “no warning can save people determined to grow suddenly rich”.
The rush into global mega-caps has occurred for very rational reasons – the lack of a clear alternative, and the belief that the sector offers safety, of sorts. The businesses themselves are likely to prove more or less bulletproof – they’re in better shape than most of the sovereign jurisdictions in which they operate.
But safe they are not. This is because they violate the most fundamental investment principle advocated by the great value investor, Benjamin Graham. They offer no “margin of safety” – that buffer that comes from buying high-quality businesses at a meaningful discount to their inherent underlying value. And this is the defining problem of our time.
Seven years of QE, zero interest-rate policy (ZIRP) and now negative interest-rate policy (NIRP) mean that most sectors of the stockmarket, especially in America, are expensive.
These global mega-cap businesses may have high-quality managements and decent international franchises, but they are not cheap. A similar trend occurred in the early 1970s. Investors flooded into the dominant global players of the day, the so-called ‘Nifty Fifty’ – into the likes of Coca-Cola (again), Gillette and IBM, driving their p/e ratios and their price/book ratios through the roof. When the stockmarket then buckled, the share prices of these companies halved – or worse.
Sure, relative to cash or bonds, stockmarkets clearly look attractive today. But the most important aspect of any investment you make is the starting price you pay for it. That holds whether you buy stocks, bonds or property. Valuation is everything. The sad reality is that not all stocks are created equal.
Your mission, and the mission of any value investor today, should you choose to accept it, is to identify high quality (of business franchise and management) without paying a premium for it. That mission is difficult, but not impossible.
But we need to look further afield. The US is largely out of the picture. Asia looks more promising – and Japan especially. A two-decade bear market has left many high-quality Japanese companies trading on multiples that even Ben Graham would be salivating over. It’s been a MoneyWeek favourite for a while – and it’s one of the few stockmarkets I’d be happy to stick with for now.
• Tim Price is director of investment at PFP Wealth Management. He writes The Price Report newsletter with Doug Pritchard.
Category: Market updates