Challenging a popular view helps us uncover hidden opportunities and avoid hidden risks.
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.
Thanks for the interesting article. Personally it feels to me like the belief in the old fundamentals and assessment of risk that drove share (and other asset) values has been temporarily suspended by the enormous amount of QE. I can’t help feeling like when the ‘music stops’, its going to end badly.
Hi Jim
Thanks for your comment on the article. I agree – the extent of QE and historically low interest rates makes it feel painful to hold cash, and unfortunately entices investors to take risk without concern for long-term valuation. We can’t know when things will revert from extremes, so we just focus on avoiding the popular areas where overpayment is likely, and instead look at out of favour ideas, where we can stick to our valuation discipline (and be very patient!).
Residential property “investors” (of the “mum and dad” variety) are a great example of what happens when sense and sensibility are thrown out the window. After maintenance fees, insurance, agent fees and periods of vacancy most will be lucky to see their EBIT break 2% p.a. Then, with the depreciation of structure and capital appreciation of land (which, over the long-term tracks fairly close to inflation) most investors will be lucky to see a return more than 1% above inflation. A good return for government treasuries. An ok return for bank term deposits. A terrible return for a moderately volatile asset that’s propped up on mountain of debt. For the moment, the head in the sand seems to be working well for most, but when reality hits I foresee the public outcry “why didn’t anyone see this coming”.
Thanks for your comments Joel. A good way to look at it – most people don’t mentally place property in as risky a category as it deserves, particularly given the typical leverage. Nor do they conduct a rational assessment of prospective returns as you have. As you allude to, it can’t go on for ever and when things revert, some upset seems likely. The tricky thing for those who still believe in principles of valuation is that this behaviour can go on for a long time. I try to keep in mind this quote from Rudiger Dornbusch: “The crisis takes a much longer time coming than you think and then it happens much faster than you would have thought.”
This is not new.
History for those who heed it tells us that people paid vast sums for tulips in Holland At the peak of tulip mania, in March 1637, some single tulip bulbs sold for more than 10 times the annual income of a skilled craftsman. It is generally considered the first recorded speculative bubble.
More recently in ENgland early 90’s properties devalued to such an extent that the mortgages were greater than their valuations!!
Then there was the tech wreck.
The property bubble in Auckland NZ and Sydney will come to a painful end for some!!
Hi John
Thank you for your comment. Indeed, financial history has been punctuated with some spectacular overvaluation bubbles. And it is important for investors to remember that overvaluations are present in the market at all times, even when these overvaluations are not as spectacular. Avoiding overvalued investments is the first step to preserving and growing your wealth.
In the context of the Australian share market, the banks, and more generally shares perceived as “blue chip yield” stocks, would seem to be areas of potential overvaluation and unrecognised risk. The fact that the financial sector now accounts for almost half of the entire market capitalisation of ASX shares should be enough to make investors stop and think. (But it probably isn’t!)