Sandy Nairn, the CEO of Edinburgh Partners, is a value investor who spent 10 years learning his craft working for Sir John Templeton. When I interviewed him recently, he explains why in the last few weeks he has turned from being very bearish to moderately optimistic. He shares the view that equities have gone from being overvalued to somewhere around fair value.
While that means they could easily fall further in the short term, a good stockpicker should be confident that good returns will be there for those who buy now. Here are a couple of extracts from his answers. The full interview can be downloaded from the Edinburgh Partners website.
Why investors are still cautious:
“This worry is based on the concern that we face a return to the 1930s. For a time that was a disturbingly plausible outcome. So long as the talk was of moral hazard, there was a danger that the entire financial system would implode. The US authorities were the first to realize the gravity of the situation and whilst history may criticise the techniques that have been used, I think the outcome is that the sanctity of the banking system has been preserved”.
“As I have mentioned, the 1930s was not a unique event. It was merely the latest in a series of financial meltdowns which morphed into disastrous declines in the real economy. The lessons learned from that experience have underpinned recent actions and are the reason why we have not had a repeat since that time. The problem then was that liquidity was withdrawn from the banking system rather than pumped in”.
“There was no co-ordinated central banking system, and on top of that, you had the Smoot-Hawley trade legislation, which brought in a whole series of trade barriers and tariffs that decimated the global economy. Whilst there remain many who hark back to the supposed golden days of the gold standard, there is no question that it too was a contributory factor to the economic declines which followed. We don’t have these things now”.
On the impact of the credit crunch:
“I expect the outcome will be at least two years of seriously sub-trend economic growth, with a particularly virulent impact on white collar service employment. I don’t think this view is any longer different from the consensus. Indeed I think one of the things that is happening at the moment is that markets are becoming fixated with that two year period, and whether or not it turns out to be an over or under estimate of what we eventually experience”.
“If you do not believe that the risk of deflation has been averted, or if you believe that a depression is nigh, then clearly you want to hold the safest bonds you can find and nothing else. If you believe that the fork in the road leads in a different direction, then these are the last assets you would wish to own. It seems to me that Government bonds are currently attractive only if you believe in some form of prolonged deflation”.
“All this focus on doom and gloom is meanwhile also creating opportunities for investors with a medium/long-term horizon. Excessively short time horizons are the fundamental and repeating imperfection in modern financial markets. Some describe it in terms of ‘fear and greed’, but the root cause is that we tend to extrapolate whatever we are experiencing now into the future. For example, 12-18 months ago economic conditions looked relatively benign but it was really difficult to find stocks that were cheap on a meaningful long-term view. It only made sense if you adopted the view that the cycle had been abolished”.
“Since few such bargains were available, all you could do was seek to identify stocks that were reasonable value but low risk. Everything is ultimately a risk/reward issue, and if you chase alleged cheapness at the tail end of a bull market, typically what you end up doing is simply pushing up the risk profile of the portfolio at just the wrong time. Emerging markets was the obvious example of this. The risk profile looked way, way too high, with the principal justification being all the nonsense about decoupling”.
“This has now reversed. Economic conditions are far from benign and deteriorating, but it is difficult to find stocks that are expensive on a long-term view, unless you still feel that the cycle has been abolished! For example, we are finding companies in emerging markets whose share prices are down 80%. Their risk profile has improved substantially simply because the valuation is down so much. In recent weeks and months we have purchased share ranging from China Mobile to Baidu to Samsung Electronics, all of them at prices which we feel more than discount the near-term risks”.
“Today everyone is understandably focussing on short-term risk, and on what will happen during 2009 during the recessionary period. Few are focussing on the longer-term. Risk is still important, but if solvency is solid and long-term returns are potentially high, then the opportunities need to be grasped, and grasped now. This is where I think we are now”.
“There comes a point when share prices fall enough that you have a sufficient margin of error to be very confident about long-term returns. In other words, even in the worst plausible case you are unlikely to lose money. Right now, there are an increasing number of companies that, in this terminology, I view as relatively low risk”.
“It doesn’t mean that their share prices may not fall in the short run – no-one can predict those movements with confidence – but in the long run, you can have a high degree of confidence about the earnings profile and hence the valuation. Cisco would be a prime example of such a company. The long-term earnings profile is one of reasonable growth, the balance sheet is rock solid and the company is well managed. Recent months have added the final, and most important, ingredient of a low share price”.
“In the long-run, by which I mean five year periods, rather than an indefinite ‘in the long-run we are all dead’ time horizon, the evidence is compelling that share price returns mirror valuations. We have studied the relationship between low starting p/es and five year returns across all markets and all time periods, and the correlation is both universal and unambiguous. It is the simple fact that share prices are periodically hit so hard that creates these opportunities. It is also why I now have a much more optimistic view”.
Where are you finding the opportunities?
“Technology, primarily in the US, is certainly one. It’s beginning to spread to the rest of the world. Capital expenditure related companies are going to have an awful couple of years, because I guess the one thing companies can do is defer capital. We’re seeing Japanese robotics and machine tool companies which are world leaders in process technology terms but whose share prices are down 60-70%”.
“Sure, they were overvalued to begin with, but you can be pretty certain that on a five year view you’re going to make good money from them. You have to be careful about the losses which those companies will sustain in the next couple of years if cap ex gets suspended. With one company we invested in, Fanuc, the share price went from 7,000 to 5,000 in the space of a week! That was an opportunity to pick up more shares and there are many more of them appearing”.
“China is the other major area where we have gone from almost zero exposure to north of 6% in a very short space of time. Having believed the ‘decoupling’ story to a ridiculous extrapolation of the economic importance of China, we have seen a complete turnaround in sentiment to the extent that some share prices are down 70-80%. That is creating an opportunity for us to invest with what we regard as some of the best risk reward propositions”.