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Rewarding Rubbish

In the latter half of calendar 2013, investors (and I apply that definition loosely) rewarded those companies that were of lower quality, bidding their prices up to effect a stock market rally that have made many look like geniuses.

As John F. Kennedy noted wryly, a rising tide lifts all boats. But it was Warren Buffett who later observed; it’s only when the tide goes out that you see who was swimming naked.

As you may know, at The Montgomery Fund we carve up the universe of stocks around the world by rating every listed company from A1 down to C5. A C5 company has the highest risk of going broke. Gunns Timber, Hastie Group and Autodom were all C5s for some years before plunging into stock market folklore. Elders, whose woes have seen the company search for buyers and whose share price has collapsed from over $22 in 2008, to 13 cents today, has been annually rated sub-investment grade since 2008. In other words, the quality scoring system appears to have some merit anecdotally. As an aside, we’ve also had it academically verified.

But the market doesn’t always agree that investing in quality is the way to go.
From 1 July 2013 to 22 January this year, high quality companies have done less well, in aggregate, than poorer quality companies.

By way of example, healthcare stocks that we rate investment-grade rose 28 per cent from 1 July 2013 to 22 January 2014, but those we rate sub-investment grade rallied 51 per cent. Similarly, in the consumer staples sector, those stocks that Montgomery rates investment-grade rose just 0.8 per cent, while those that we rate sub investment-grade rallied 53.9 per cent in aggregate. Finally, in the consumer discretionary sector, investment-grade stocks rallied 17.1 per cent, but sub investment-grade rallied 43.1 per cent.

Is something wrong with our rating system? No. In the long run, investing in quality at prices below our estimate of their value works – and it works well. But it doesn’t work all of the time.

Think for a moment about a rather oft-heard piece of commentary that investors are “switching out of defensives into cyclicals”. When you hear this, what you are hearing is a statement about the belief held by some advisers and analysts that now is the time to expose more of your portfolio to those companies that are more acutely exposed to the vagaries of the economy.

BHP is a company regarded as cyclical. Its consensus normalised profit this year is expected to be no higher than it was seven years ago, back in 2007. Yet it has increased the amount of money it’s borrowed to help achieve this result from $14 billion to $38 billion. That’s what we call cyclical. 

Airlines are also regarded as cyclical companies. Suppose, however, you were privately starting up Virgin Airlines in 2003 with a personally autographed cheque for $184 million dollars of your own capital, and personally guaranteed borrowings of $139 million. After just one year in business, you generated a $110 million profit, equivalent to a near 60 per cent return on your $184 million equity investment.

Fast-forward ten years, to 2014, and the business is losing $96 million [a year?]. The year before, it made just $44 million and the year before that it lost $65 million.

With profits so much lower than a decade ago, you’d probably like to take your cyclical business and put it somewhere less painful.

Not only are your airline’s profits now much, much lower than a decade ago when you kicked the business off, but to produce this result you have also written cheques to the tune of an additional $860 million in equity capital to support the business. Meanwhile, you still haven’t paid off that $139 million you borrowed back in 2003. In fact, you’ve borrowed even more to keep this cyclical business going and you now owe the banks a whopping $1.9 billion!

These unattractive economics are not uncommon amongst cyclical businesses or those that score poorly using our quality scoring approach. 

Regardless, many will believe that the market is always right, and whatever price the everyday investor is willing to pay for shares – irrespective of whether it’s based on poor or unqualified advice or not – is the true value of the company. Rubbish!

In my view, absolute value has had very little to do with the recent trend of poor quality company outperformance. Much of it, however, can be attributed to the equally spurious investment strategy based on relative value. 

Many analysts believe that if the best quality companies have already rallied hard and their aggregate price to earnings ratio (PE ratio) is, for argument’s sake, 18, and a security in the same sector can be found with a PE ratio of 12, then the rationale goes that it’s time for the stock with the PE ratio of 12 to catch up.

Our current thinking is that the market rally in the early part of 2013 eroded most of the value that was observable prior to that. There was still some relative value available among the lower quality companies, so much of the market gains more recently have been driven by a rally in the laggards.

The pattern is not without precedent. High quality companies rally first and then, desperate to generate activity, advisers encourage the latecomers to purchase those companies that haven’t caught up. But the idea that company X should have a higher share price because its peers are now at 1.3X, is logic that’s akin to suggesting a Volkswagen Kombi will beat a Ferrari in the next race because the Ferrari has won every race prior. 

Unjustified by valuations and the economics of a business, the shares of some companies can indeed rally strongly and remain high for a time, but in the long run, share prices follow the economics of a business and its resultant valuation.

It should come as no surprise then that Virgin’s share price, which was over $2.30 ten years ago, is now struggling under 40 cents.

As Buffett also advised: “If you aren’t happy to own the whole business for ten years, don’t buy a little piece of it for ten minutes.”

This sensible piece of advice is easily forgotten by those brokerages whose need to generate profits requires activity on the part of their clients. But sound advice, which is the preserve of many brokerages most of the time, can give way occasionally to some absurd examples. Witness, for example, this suggestion by one international broker:

As we are proposing a move away from quality, which has performed well in recent years… provides the opportunity for portfolio managers to consider the merits of some of the less fundamentally favoured stocks… as they will likely provide the most alpha...

Just as the steam rises from dog dung in winter, so too can the price of rubbish companies in the short run. In the long run, they fall right back again and you’d have to be a very clever gambler to know precisely when the steam will stop rising. 

While the rubbish is running, it’s hard not to be tempted from one’s own strategy, especially as there’s a regret that emerges when prices for all stocks broadly rise. But don’t regret the gains that were missed – the risks aren’t worth it when the tide goes out and you’re left swimming naked.

 
Roger Montgomery
Roger Montgomery

Roger shares his stock market insights at his Insights blog, blog.rogermontogmery.com. Investors can also follow Roger on Facebook and watch media interviews at his YouTube channel. Grab your Second Edition copy of Value.able and learn how Roger Montgomery values the best stocks and buys them for less than they're worth. Grab the book now at special price!