Observations: Potential Returns & Risks
At Clime we are keen observers of successful long term investors and follow with interest some broad indicators to help us gauge the temperature of equity markets both locally and internationally. There are several reasons for this, when equity markets are unpopular there are often broad based investing opportunities for the prepared and during times of optimism (and high prices) few opportunities exist and risk of not achieving adequate returns is elevated.
Three of the broad indicators we follow are:
1. The Buffett Indicator
2. The Schiller CAPE
3. Clime’s Global Equity Market Valuations
Warren Buffett has described the ratio of US Corporate Equities to GDP as ‘probably the best single measure of where valuations stand at any given moment‘.
This ratio continues to expand and recently exceeded two standard deviations above the long term mean. US equities are clearly not cheap on this metric. Certainly something that should make investors pause and consider.
Figure 1. The Buffett Indicator
As can be seen below, Berkshire’s cash holdings are at record levels, it is likely fair to say that Warren Buffett is struggling to find sufficient opportunities to deploy Berkshire’s cash at acceptable risk levels. Buffett has clearly been successful in the deployment of capital over long stretches and it is interesting to observe his cash holdings over time.
Figure 2. Berkshire’s Cash Holdings
Looking at earnings smoothed over time was pioneered by Benjamin Graham & David Dodd where they argued it was sensible to observe earnings power over time rather than at any one point in time to adjust for the business cycle and the inherent volatility in any one periods earnings. This work was progressed by Nobel Prize winning economist Robert Schiller in more recent times where his work suggests in periods where the CAPE (cyclically adjusted price to earnings ratio) is elevated and prospective returns are suppressed.
Figure 3. CAPE Price E10 Ratio
It is interesting to observe the previous times the CAPE was at similar levels to today: 1901, 1929, 1966, 2000 & 2007. These periods were followed by poor outcomes for investors with 5 year compound annual growth rates (CAGR) of 3.1%, -24.0%, -3.2%, -1.0% & -1.0%.
Of course that is not to say today will mirror the five historical experiences of such high CAPE readings, for a better outcome today we would need to observe significantly stronger corporate earnings and/or significantly lower interest rates. We know interest rates cannot go much lower than here and the jury is out on significantly higher corporate profits, as they are already breaking new ground as a percentage of US GDP. The risk seems to be to the downside over the medium term with interest rates likely to increase and perhaps corporate profits moderating toward the longer term mean as a percentage of US GDP.
Figure 4. Corporate Profit after tax / Gross Domestic Product
Source. Federal Reserve Economic Data (FRED)
At Clime we follow and value 40 global markets as a broad screening tool for finding areas of the global equity market that look attractive as a focus point to research individual companies of interest. Our valuation method at the market level is identical to the process we use for individual equities where we consider the equity deployed, the earnings generated, the dividends paid and a fair discount rate for the market being considered.
Figure 5. Table of G7 Value & Price
Our work shows that when scanning global equity markets there is a low level of present opportunity. Indeed if one was to consider the MSCI World Index which captures 85% of all global market capitalisation, the five year total shareholder return (TSR) potential is 4.7% if one was to assume the long term earnings growth demonstrated over the last thirty years. For US equities the 5y TSR potential is 3.2% and for local Australian equities the 5y TSR potential is somewhat better at 9.0% as the local market is not as expensive as the World or US markets.
It is apparent today that equity prices are high and prospective returns are below average, perhaps well below. Recency bias is likely the psychological trait influencing markets at present. Timing is of course uncertain, however the high prices are the best indicator of poor forward returns whether it be for tulip bulbs, Nifty Fifty names or Dotcom stocks. We may not be there just yet and no one rings a bell at the top. Preparation is always best done before markets start to shake.
Volatility to us is not risk, it is opportunity. Volatility is only a risk if the investor is leveraged or does not have the conviction to stick with an investment in the face of price changes; equity markets have an uncanny ability to test an investor’s conviction. Risk to us is the chance of loss of purchasing power. High prices and poor balance sheets are the key sources of risk. Equities individually and collectively are risky and require an investor to demand they are compensated appropriately. The debate of the day is around discount rates, on one hand the journalists are arguing for reductions to discount rates so they can create more ‘perceived’ opportunities in today’s historically expensive markets. At Clime we are maintaining our discipline and steering clear of the noise generators of the day and ensuring our investors are compensated fairly for the risk of holding equity investments. Indeed several fund managers are sticking to their processes and discipline, notables include Magellan and Airlie. Journalists are remunerated by headlines, very different to the ways investors are rewarded, dividends and capital gains. Avoid the noise generators. Focus on those with the responsibility and fiduciary duty.
At Clime we focus on absolute returns, we seek to avoid permanent impairment of purchasing power and seek double digit return profiles from the equities we invest in. We screen for business model & competitive advantage, strong profitability, strong free-cash flow, a strong balance sheet and rate highly strong insider ownership. This is the discipline and we don’t stray. Taken together, these criteria go a long way to keeping us away from permanent loss on an individual common stock holding for our clients.
As a fund manager it is important to examine our own biases and the requirements of our clients to determine whether bailing out deep into a decline in the market is a real possibility. We seek out investors who expect a good share market shake once every five years and typically a greater than 10% decline every year or so. We ask our investors to focus on five to seven year returns which reward them for their patience and are long enough to show the value added by the investment team free from market zigs and zags. Importantly, we communicate our process and conviction transparently to our investors in buoyant markets and in soft market environments alike which contributes to our clients long term uninterrupted equity investing journey.
Figure 6. Clime Australian Value Fund & Clime Capital Returns (January 09 – August 14)
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John Abernethy is the Chief Investment Officer (CIO), Executive Director of Clime Investment Management (Clime Group) and Chairman of Clime Capital Limited.