In the 1800s, the idea of listening to music without being in the presence of the musician and their instruments was unthinkable. After hearing one of the first music recordings, one composer declared that he was ‘astonished and somewhat terrified’. How on earth do you explain a voice without a body? Thomas Edison’s hard work and innovative thinking that led to the recording of the human voice with a phonograph and the evolution of recorded music now enables us to listen to music whenever and wherever we choose.
Success in investing also often involves being willing to think the unthinkable. As billionaire asset manager Howard Marks has said, ‘most great investments begin in discomfort’. Importantly, the conviction to pursue a contrarian idea to the point of success is built on first doing the hard work to understand it.
Objective and disciplined analysis is crucial to investment success
As far as possible, emotion and conjecture should be removed from the investment process, and decisions should be based on logic and fact. With investing, the way we analyse and interpret information determines whether we succeed or fail.
Looking beyond the obvious to find value
What makes investing hard is that the way things appear on the surface is often misleading. A good company is not necessarily a good investment. Everyone can see the obvious positive features like good products, high profitability and growing earnings that make a good company popular. What most people miss is that everyone else sees the same thing. In fact it is very human to look for confirmation that others see the same thing. But the problem with something being popular is that competition is high, and the price tends to be higher than it should.
Australian residential property – when competition drives out valuation discipline
In Sydney and Melbourne, competition for residential property is fierce. As a result, the seller, rather than the buyer has the bargaining power, causing prices to rise strongly. In a circular fashion, others are motivated both to participate in this rise and to avoid getting left behind.
In this environment, many will borrow far more money than a prudent assessment would advise. But they interpret this as fine and normal – after all, prices are going up and mortgage rates are lower than ever (as shown in the chart), so they feel they can manage more debt than ever. The mentality quite literally becomes ‘buy ‘til it hurts’.
This situation escalates when valuation discipline is low – and this discipline is now largely absent. Today’s property buyers tend to look at what the last four or five similar properties sold for to establish what price they should pay.
But is that a sensible approach to valuation? Do they know those four or five people who bid highest for the other properties? Are some of them now spending 70% of their income servicing the debt? Will they be okay if today’s record low mortgage rates eventually move back to the long-term average of 8.5%? These buyers are essentially abdicating their responsibility for valuation, instead relying on people they don’t know.
A valuation discipline is essential to avoid hidden risks
Similar behaviour is evident in the sharemarket regarding the popularity of large, blue chip stocks, with investors focussing on the word ‘yield’. But as more people take the same risk, the price rises, and the more risky that position becomes.
It is impossible to know in advance when a favourable situation will turn ugly or an unfavourable situation will improve. Therefore an unemotional and disciplined valuation framework can be a critical aid in evaluating risk. This helps identify and avoid the popular ideas that appear to offer more immediate benefits, but which tend to have significant hidden risks.
Investing in unpopular businesses and hidden opportunities gives you back your bargaining power
At Allan Gray, we always challenge the popular view, and try to look at things differently. Combined with a strong valuation discipline, this enables us to find overlooked opportunities, where we will have the bargaining power. Importantly, it also prepares us to recognise when an alluring tune is more likely a siren song.