Adopting a private investment mindset to listed markets
Why do we remember some things as clearly as the day they happened decades later, yet in other circumstances cannot remember what we did last Tuesday? The answer is generally that it depends on the significance of the event and the impact it had on us at the time.
The birth of a first child is life-changing and unlikely to be forgotten quickly. The plain salad sandwich that proved to be the highlight of last Tuesday is less memorable. Dramatic events linger for longer and more vividly in the mind, often particularly so if they have negative associations or feelings attached to them. They certainly feel more recent than they are.
It is hard to believe that it has been well over a year since the start of the global COVID-19 pandemic. Even harder still to believe that the Global Financial Crisis was more than a decade ago. For investors who experienced either period of turmoil, these memories are often vivid, the periods influential and even formative to their approach to investment.
In the first half of this newsletter, we reflect on some of our observations from the last 18 months. We hope you find these interesting and thought-provoking, while also giving you some insight into the way we think about investing. In the second half, we discuss the rationale behind our investments in the real estate sector.
Time horizons, defining long term investing
In our view, all sensible investing is long term in nature and design when the investment is made. This enables the benefits of compounding returns to have a good effect and, over time, provides the best opportunity to generate substantial wealth. What is a long term approach to investing? It seems a simple question with such an obvious answer. It is buying an asset today, with cash that is unlikely to be required for a considerable period of time, with the expectation that it will grow its cash flow and hence increase in value over time, either paying out or reinvesting the cash flow it generates. This is the approach we try to adopt when investing in equities.
We are buying a stake in a business, that we intend to hold for a considerable length of time and where we see substantial upside from an earnings and valuation perspective, with the asset generating good cash flow to us as a part-owner. It is no different to buying a property or a private business.
Turning advantage into disadvantage: The liquidity pitfall
Many investors in listed markets would quote the same long term approach. Yet somehow daily quotations can gradually degrade even the best of long term intentions. Daily price fluctuations convince people that they should act on them, often to their detriment. The idea that the market is there to serve you, not instruct you, is frequently quoted but less often adhered to, particularly during periods of stress. A lowball offer for your home would get little attention. In fact, most people would scoff at such a suggestion. A low quote for your neighbour’s house would have many wondering, assuming they have the means, whether they should snap up a bargain! And this is the correct approach. Yet listed markets are somehow different. Low and frequent quotes seem to encourage people to sell. It is difficult to imagine more frequent quotes than every second of every business day between 10am and 4pm. And in this way listed markets can do significant harm to individual investors.
Similarly, market prices are often used as the basis for valuation. Markets are assumed to be efficient, which is frequently far from reality. We suggest that at most times it is possible to find some companies that will never earn, over their lifetimes, undiscounted aggregate cash flows close to their current market capitalisation. Such stocks are definitionally overvalued because a company is only worth the present value of all future cash flows. But when markets become enamoured with particular stocks or sectors, investors and analysts find ways of justifying the valuation. Often what they are really doing is assuming the collective market has a better understanding of the stock’s value than they could, so the valuation the market is ascribing to the stock must be “in the ballpark”.
Research price targets are inevitably clustered within 15% of the current share price. Even during market calamities like COVID-19, analysts rarely pound the table with stock suggestions where they see upside targets more than 100% above current valuations. The assumption is that such a valuation must be wrong because the market could not be that far off. This mindset encourages the same behaviour, that somehow the market selloff and changed conditions justify absurdly low valuations, and therefore one should dare not think about buying at said prices.
The stock market is the juxtaposition of financial principles and human psychology. Having a sound understanding of both is a requirement for successful participation. Understanding one’s own psychology, as much as recognising the collective psychology of others and therefore the broader market, is most important at the extremes because extreme emotion drives extreme behaviour. The stock market has a tendency over time to swing from irrational exuberance to irrational fear and back again, reflecting the behavioural impulses of its participants. Recognition of this is important because it leads to the
conclusion that market quotations during euphoric periods and particularly in broad market panics tell you very little about the underlying value of a business. So if not in a position to take advantage of panic and buy, the best thing to do is nothing, particularly if you are confident in the quality of the businesses that you own a share of.
There is a certain irony in the increasing popularity of private equity funds in asset allocation. We look at many of the businesses owned by private equity and conclude that they appear to be, on average, inferior to the businesses the Fund holds in the listed market based on return on capital, market share and hence economies of scale, quality, resilience and management expertise. In any economic shock, they are likely to suffer financially more than the businesses the Fund owns, and in genuine unexpected stress they are likely to have less funding alternatives available to them. Yet the perception is that many of these businesses sailed through the COVID-19 crisis. In many instances nothing could be further from the truth. What most people are referring to is the absence of marked-to-market pricing during this period of stress. Director valuations most likely outlined a modest decline in valuation and then a subsequent bounceback. But these valuations were based on rational financial analysis, absent the element of human emotion. The reality would have been very different had all of the investments been listed. The lack of regular pricing and liquidity worked to the funds’ advantage and clients’ advantage, preventing unnecessary self-harm.
It is ironic therefore that more and more frequent liquidity is being demanded of managed funds operating in the listed space. Daily liquidity to get into and out of a fund is almost a prerequisite for broad market acceptance. This liquidity demand appears completely at odds with the sensible recommended time frames for investing. In the case of the Auscap Fund, this is 5 years plus. Having a long term investment approach is very important. Most people make very considered thoughtful decisions prior to investing with a manager. But then often the decision to redeem might be made on a whim, or in reaction to an emotional response, thereby undoing the value of the thoughtful initial consideration.
Long-term investing and the random walk of markets
At Auscap, we invest in businesses for the long term. This should be obvious to anyone who has followed the Auscap Fund and its investments over the years. We are a long term shareholder in the businesses we own. The reason a long term approach is best is that it allows the underlying value creation within the businesses to dictate returns. This is important. Over the short term, the returns are far more a function of market sentiment and the random walk of the market.
To illustrate this, consider the hypothetical investment fund performance chart below.
Here we assume that the intrinsic value of this hypothetical fund portfolio is best represented by the yellow line. The good businesses the fund owns are gradually increasing their intrinsic value. In this simplified example we assume value creation is consistent over time. By contrast, the fund’s actual performance is demonstrated by the red line. There are times when the manager’s style and stocks are in favour, such as at B and C, and other times when this is clearly not the case, such as at D. Despite the stability of the underlying value creation, the effect daily prices can have on investor psychology is extreme. Let us take a look assuming an investment is made at the four points, A, B, C and D.
Investor A probably feels relatively comfortable for most of the investment period, potentially excluding the short period after investment when returns were negative. They might also be nervous at D, if the manager has underperformed for a few years. They might start asking whether the manager’s investment approach has changed or whether they have lost their touch. Assuming the manager’s approach and communication are consistent, they retain their faith and have a positive experience from A to E.
This is very different from investor B, who is happy at point C, but unlikely to be so at point D, when returns over his 4 years of investment appear meagre. Investor C is outright despondent at D. They may even assume they have made a calamitous decision investing with this manager. This is where it is most important to objectively reassess the investment rationale and seek to understand what has happened to cause the poor performance. Is the manager appearing consistent in approach? Have they faced natural headwinds or tailwinds? What is the communication like between investor and manager? Has there been any style drift or is the manager being consistent? Was the manager buying stocks at C and dumping them at D, leading to permanent loss of capital? Asking these questions will most likely lead to a sensible decision. For those who determine that the manager has remained consistent, communicative, humble and open, and therefore remain invested, there is satisfaction at point E, which should give the investor confidence to continue to take a long term approach to this investment.
How should the move from C to D be considered? Should the manager be criticised for how the portfolio of stocks performed over this period? The chances are high that the same stocks that caused the prices to move from C to D caused the move from D to E. An assessment needs to be made, on reflection, of the manager’s decisions through this period. This assessment should not be based on price action, but rather on the performance of the companies in which the manager was invested. If those same companies generated the performance to E, then C to D was more likely a function of the vagaries of the market. This is why trying to time the market or to time an investment in a manager is a futile exercise. It is also why the best approach to investment in markets or managers is to take a long term approach.
Even if a portfolio of well-selected investments creates value consistently over time, as reflected by the yellow line in the chart above, daily price fluctuations mean that how this would appear to investors in a listed environment would be quite different. The example we have used assumes no moves outside of two standard deviations from the mean, the upper and lower bounds shown, in line with what might statistically be expected. In reality, neither of these conditions, consistent value creation and a standard distribution of stock and market returns exist in financial markets. This introduces further variance, particularly if a manager runs a concentrated portfolio. COVID-19 was a one in 100-year event, definitionally more than two standard deviations from the mean, implying a move below the downside price variance shown in the chart. Spending too much time listening to the market to select investments will more likely lead to selecting stocks or managers after they have had a period of good performance, such as at points B and C, rather than making a decision to invest at D when the great opportunity exists. The investment manager’s role is to select businesses capable of increasing their intrinsic value substantially over time. This can only be done if one takes a long term approach.
Confusing preservation of capital with price volatility
One of the most discussed, focused on and misused terms in the market is “preservation of capital”. Almost every manager quotes it as an objective of the investment process, but what does it mean? It means not buying something and then selling it later at a loss. It is reflective of an error made in purchase where the investment thesis was incorrect, the valuation was excessive and/or circumstances have changed such that the assessment of value is much lower and therefore justifies the sale of the asset even though the price is lower. A manager who purchases investments with a significant margin of safety between the purchase price and fair value will not have such an experience frequently. Whilst unfortunate surprises will still happen, buying high-quality businesses with an initial margin of safety is the key way we look to protect capital over time.
Preservation of capital is not about minimising volatility. It is not about ensuring a portfolio does not have drawdowns in the aggregate quoted valuation of the businesses it holds. “Drawdowns” are not reflective of poor preservation of capital any more than your neighbour deciding to sell his house in a short downturn for an absurdly low price and clear capital loss would be reflective of your own capital preservation skills. It is only poor preservation of capital if you also need to or choose to sell your own house at this low price creating a capital loss. This distinction is very important. Why? Because confusing the preservation of capital with stock price volatility will lead to a focus on things that are beyond the control of any manager.
A manager who focuses too heavily on avoiding performance volatility runs the risk of missing some great long term investment opportunities if investing in these opportunities are in conflict with their short term desire to lower fund volatility. The greatest opportunities are often present in the most volatile market conditions. Dampening investment volatility through some diversification is sensible. We think a portfolio of approximately 40 investments in listed equities is sufficient diversification to achieve a reasonable lessening of volatility in most circumstances. Similarly, some stocks and sectors exhibit lower volatility over time, and being aware of this is also sensible. But trying to lower volatility will either result in “index hugging”, largely replicating the index against which the manager is measured by sector and even large individual company weights, so that volatility is always similar to the index and therefore “acceptable”, or by trying to time the market. Index hugging is clearly not investing to maximise risk-adjusted returns, because the risk-reward for individual investments is not proportionate to their size. And we think trying to lower fund volatility by trying to time the market, investing in stocks when a manager thinks they will appreciate and exiting before they think they will depreciate, is fraught with danger.
History would suggest that it is impossible for any individual to consistently time the market in this way. Our view is that trying to time the market is a folly. One can be aware of circumstances that positively and negatively impact the outlook for individual companies, but absent new information or circumstances materially changing the investment thesis, investing, divesting and reinvesting in positions one wishes to hold for the long term to try to minimise negative short term investment performance is an impossible task. It is also tax inefficient, mentally taxing and takes time and effort away from the primary concern of selecting attractive long term investments and monitoring developments across these investments closely.
Market liquidity should provide investors with an additional opportunity to improve returns, by taking advantage of extremes in sentiment. Market liquidity may even allow an investor to exit one investment, even at a loss, because another opportunity is significantly more compelling from a risk-adjusted return perspective, an aspect of portfolio optimisation. But we are not of the view that available liquidity should be used to guess where share prices are going over short time periods, an impossible task.
Path dependency and the role of luck
The other observation we can make about the chart above is the random nature of short term performance and the role of luck in this process. Yet path dependency can create a strong perception of a manager from an investor’s perspective. People naturally focus on what happens from the point at which they invest, which is entirely understandable. However, while the path of performance will be noticed, in the short term it is beyond the control of the manager. Whether good performance occurs in clumps followed by retracements or is reasonably even and linear, is not something the manager determines. Whether an investment style has been in favour or out of favour, and whether it comes in and out of favour quickly or has long periods in the wilderness, are also factors beyond the manager’s control. Investors frequently evaluate managers based on actual short term outcomes, without recognising that such outcomes are often a function of random unpredictable events. This is the random walk of markets. It is over the long term that investment outcomes are a function of the level of investment skill.
The investment performance path a portfolio of 40 investments takes could deviate substantially even if the portfolio ended up in the exact same spot at the end of 5 years. Anyone who has run a Monte Carlo simulation based on a number of variables would be aware of this. There are almost infinite variables affecting stock markets. Yet the role and impact of events on stocks prices at different points can lead to vastly different conclusions about a manager.
Take the following
hypothetical performance chart and assume that the investment portfolio
represented starts at point A and ends up at point B after 5 years.
The way prices fluctuate, and the random walk of markets, would result in many possible paths to get there. In this example we assume the most extreme upper and lower paths are defined by the yellow line and the blue line respectively. We have added two other paths of the infinite possibilities into the equation, the green and red lines. The valuation path of the listed portfolio might take any of these routes, or numerous others. This is the short term random walk of the market. Yet investors will take their cues from this. The yellow path might draw the conclusion that the investment manager is a high risk taker, with enormous initial outperformance followed by a significant drawdown. The blue path might lead to the conclusion the manager took their time to get going, but at point B they are now hitting their stride. The green path might be interpreted as a very stable outperforming manager who is excellent in every regard. Yet the red line might be interpreted as a manager who is very volatile, and therefore risky. Many different conclusions for the same manager invested in the same stocks that achieve the same outcome, all because of the random walk of markets. That is not to dismiss volatility as a potential indicator of risk, but it is not the same as risk. Understanding risk is more complicated than measuring standard deviation for the one actual performance path different managers have experienced.
But if we are not to assess investment managers on the path of returns, what should they be assessed on? The best way to assess a manager in relation to delivering outperformance is the long term investment outcomes that have been delivered. And by the performance of the stocks the manager is invested in. At Auscap we are on a continual path to improving disclosure and transparency so that investors can assess our performance based on the outcomes achieved by the companies we are invested in, as well as the consistency of our approach and adherence to our core investment beliefs. This is why we recently commenced disclosing the top twenty investments in the Auscap Fund at the end of each month, rather than just the top ten. They represent the bulk of invested capital.
The discomfort associated with non-index returns
A lot of investors would like to achieve superior returns with their investment managers over time. But if the expectation is that the returns from the manager will not deviate negatively at various points from the broader market, this objective is impossible to achieve. For a manager to generate returns that are significantly superior to the relevant index, which is typically a basket of stocks weighted by size, an investment manager’s portfolio must look very different to this basket of stocks. The Auscap Fund looks nothing like the All Ordinaries Accumulation Index. This means that performance will be significantly different to this index. At different times this variance will be both positive and negative, with the objective being that on average it is considerably better than the index, otherwise investing in the index would be the way to go. But to achieve superior performance, investors must be willing the bear the deviation. It is an easy thing to acknowledge upfront, less easy to live with when a negative deviation is occurring.
We encourage all investors in the Auscap Fund to take a long term approach. The Auscap team is significantly invested in the Auscap Fund and committed to staying invested for the long term. We invest in high-quality businesses that we believe will grow their cash flows, and hence value to shareholders, over time. We modify the portfolio based on new information over time but do not fool ourselves into thinking we can time the market by jumping into and out of a wide range of stocks. This adoption of a private investment mindset to listed markets will result in the performance over the long term reflecting the value created within the businesses we own. We think this is the only sensible approach to investment in listed markets.
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Auscap manages the Auscap Long Short Australian Equities Fund and the Auscap Global Equities Fund which target solid absolute risk-adjusted returns, looking to invest in companies that generate strong cash flows and are trading at attractive prices.