Antonio, The Merchant of Venice
Socrates once flummoxed a professional orator by asking him what rhetoric was all about. Bluster slowly yields to bewilderment as the wretched orator is led by Socrates’ dialectic from one absurdity to another until at last he is forced to accept that his life’s work is nothing but a delusion. He cannot say what rhetoric is or does and can make no claim whatsoever for it. Fund managers find themselves similarly discomfited when they talk about value, their own stock in trade.
Each of them hopes he is buying it whenever he makes an investment. He starts with a conviction that somewhere in the bazaar of investment opportunities lie treasures undiscovered by all his fellows yet discernible by him. His difficulty is that he knows what he is after but is quite unable to say what it consists of or how to find it.
Bare statistics are some help to him in the search. Sometimes a dividend yield can suggest that a share is cheap, sometimes a P/E ratio, sometimes book value, very often all three. But useful as they are, if he had relied on these over the past twenty years in assessing the biggest equity market in the world, Japan’s, he would never have been in it, and for twenty years would have been egregiously wrong. No one yardstick is sufficient and infallible because in the investment business value has no enduring characteristic.
Uncertainty does not stop there. To exist at all bargains need to be generally unrecognised. An investor cannot know all there is to be known about every company he examines, and in backing his judgement against the next man has to accept that in any situation others may be better informed than he is.
Furthermore value is not an absolute quality. Investments are not cheap or dear in themselves but only compared with what else money can buy. Big British banks might look cheap enough on a 5% dividend yield but if big American ones yield 7% that may tip the scale of value. Indeed all economic assessment is relative if it is not to be worthless.
As they grope about in this maze of uncertainty it is no surprise that many investors give up and abandon the quest for value. Some become purely passive and are content to pull their investments out of a hat, convincing themselves that the results are just as good as they would be with less random methods. Or at the other extreme some design their portfolios to mirror a given index and happily ride the market tiger as it leaps and lurches.
They have given up too soon. Value is not to be dismissed as a goal just because it cannot be captured by a formula. Any brief snatch of market action will look random and chaotic. You might as well cut a tiny fragment from a big narrative fresco and expect to find order and meaning in it. Only when all the bits are put together and you observe the whole picture does it make sense. Over the piece, share prices and markets do behave logically, and their rises and falls have causes which a rational value investor can anticipate.
There are some reliable tracks he can follow. Hard financial factors and solid record are always a good starting point because they point to real achievement. But they are only a start; underlying the achievement must always be people, and before all else the quality of the people involved in an enterprise will be what determines its value. Good managers will in time reward their shareholders almost, but not quite, regardless of what they paid for their shares. Management quality seems often to be undervalued, no doubt because it is hard to quantify.
Value also shows up in the light of historical perspective and experience. Absurdities and anomalies between different classes of investment pass unnoticed in the heat of their day but stand glaring in hindsight; experience brings the benefit of hindsight to bear on today’s decision. Such anomalies mark the big shifts of direction – what Americans call inflection points – in the market. Spotting them will pay for any number of mistakes of price or timing single investments.
Yet guidelines like these serve little point unless they help lead one to value in the real world of markets today. Where do they lead?
Take the UK equity market. Conventional yardsticks point in the same direction. Ratings are undemanding, yields are adequate, profits are growing and productivity rising. Set alongside ratings in overseas markets, UK equities look quite cheap. Nor in purely domestic terms do they seem expensive looking back over a ten year comparison with yields on British Government stocks.
In ‘management’ terms, the record of the Government is exemplary compared with that of its predecessor and the Prime Minister is unchallenged.
As for anomalies within the market, there are scores of cheap companies, if speculative activity is anything to go by, whose value is rapidly being unlocked by corporate raiders. It seems as though every share is now a special situation.
All these factors might support a conclusion that the UK equity market offers good value, even after the rise so far this year. Easily reached, it should be resisted all the same because it relies on too narrow a view of value.
Too narrow, firstly, because a comparison between equity ratings in different markets offers no guide to the risk to equities as a class. All it does is provide an indication of where good or bad equity values are most likely to lie. The risk to equities as a class is rising interest rates. The threat is real because containing inflation remains, rightly or not, the priority objective of the Western world. Inflation is yet far from contained and efforts to wrestle it to the ground may well require higher interest rates.
The comparison with fixed-interest stocks is also too narrow. During an inflation, such as the world inflation of the 1970s, fixed-interest stocks become a high risk investment and their required yield rises. The relative yield of equities and fixed-interest stocks is adjusted to reflect a changed balance of risk between the two.
Over the past thirty years equity yields have been depressed and fixed-interest yields pushed up by the cult of the equity. It has been a trend born of inflation and from it springs today what we call the reverse yield gap. Disinflation will beget the opposite trend and over the next thirty years the process of the past thirty is likely to be reversed. Once prices are stable again, as they were in the 1950s, equities will become, relatively speaking, the risk investment and be priced accordingly.
The political factors also are too narrowly considered. Much good has been and more may be achieved under Mrs Thatcher’s administration. But reaction to the march of unbridled mercantilism is stirring. The pendulum has begun to swing back from the right and however imponderable the consequences, the equity market will have to face them soon.
More immediately sobering is the reflection that the UK still appears to consume more than it can afford. Current inflation figures, the running trade deficit and rising labour costs point to the fact that, despite great improvement, our performance is again lagging behind that of our competitors. It is they who determine our relative position and claims made by Nigel Lawson and others, for the UK economy need to be judged not against Britain’s past weakness but against their existing strengths.
Value judgements are soundly based only if they acknowledge all the risks as well as all the potential reward in an investment. At today’s prices the risks in the UK market are not sufficiently recognised. That is not to say that the equity market will fall tomorrow or even that it cannot mount another surge if January’s buying panic should return. Cognisance of risk does not make the worst inevitable.
Indeed, we expect that our own next move will be to raise our equity weighting substantially. Now however, with the prospects as we see them, the combination of a high real return, probability of tax-free capital gains when interest rates fall, immediate liquidity and ultimate security, makes us glad to be holding Government stocks. They are the anomaly in today’s market.
Bargain hunters should keep their eyes on HM Treasury which is buying up huge amounts of them. In Great George Street they still know value when they see it.
1 March 1989