“Don’t mistake predictability for safety”: Part 2

[private] 20th April 2013

Q and A: Sandy Nairn, CEO, Edinburgh Partners

Sandy Nairn, the CEO of Edinburgh Partners, has been a regular contributor to Independent Investor over the years, making several highly prescient calls along the way. He was extremely cautious in November 2007, just as the markets were starting to anticipate the full extent of the banking crisis, and bullish once more in March 2009, when the equity markets finally bottomed out after the severe 2007-09 bear market. Two years ago he made the case for investing in Japan. In the second part of our latest interview he argues that investors are overpaying for perceived safety: government bonds and companies with stable earnings are much more vulnerable to disappointment and capital loss than investors appear to appreciate.

What then should investors be doing now?

The danger, as I see it, is that when you should be focusing on risk, you’re focusing on return, and when you should be focusing on return, you’re focusing on risk. Return is the valuation metric that matters in the long run. Remember that inflation, the enemy of fixed interest instruments, has not gone away. It’s at its normal levels. We’re now in a world of 2-3% real GDP growth, consistent with normal levels of productivity growth. The difference is that the growth sits in those parts of the world which accumulated the wealth before, and not where it was squandered. The fact that we don’t feel it over here doesn’t mean it isn’t there!

With a government bond, you’ll get your money back, but you’ll probably drop a quarter of your purchasing power — and the outcome might be similar with the most predictable stocks. The premium applied to ‘safety stocks’ in the equity market is not as extreme as in the bond market, but quality stocks have clearly detached themselves from the rest in terms of valuations. Holding Diageo may give you a warm feeling. You have a high degree of confidence that the company will deliver its earnings, but if it’s not on a low enough valuation, you’re still liable to lose money. You risk waking up in five years’ time with the share price marginally down, and inflation running at 2%-4% per annum compound, to find you’ve lost 25% of your purchasing power.

What else might happen to the equity market in those circumstances?

If investors decided that a period of mediocre economic growth is more likely than repeated recessions (or outright deflation), will they decide to move away from companies such as consumer staples whose principal virtue lies in their earnings stability? The answer, almost certainly, is yes. Will they consider buying companies whose long-run earnings growth rates have typically been similar to that of consumer staples, but whose recent earnings have been cyclically depressed? I think so. So even without assuming a cyclical recovery in the latter’s profits, we could easily see a 20%-30% improvement in their relative performance, driven purely by reassessment of relative risk.

It may be happening already. If you accept our view is that investors’ desire for predictability has skewed valuations, then a return to this kind of normality must be on the cards. We think we are now at the point in the cycle where the investor needs to consider the potential rewards of equities more carefully, bearing in mind that safety and predictability are not interchangeable. The greatest safety may well now be in the most unloved areas where expectations are lowest. The level of skew in markets now favours value over predictability. What you’ve seen in the past 12 months, if you look at the bank sector, it has been the banks with the highest perceived risk that have been doing best. That is because the perception of the tail risk is going down. I think there’s further to go.

Might not investors’ fears be justified – tail risks still exist, don’t they?

We’re not saying that there aren’t risks, only that the probability of the worst case scenarios playing out is less than it was. The three principal tail events everyone has been worrying about – Europe breaking up, a hard landing in China, the US falling over fiscal cliff – have each diminished in terms of likelihood. Given that it is only the risk of those tail events that created the skewed valuations in the first place, it is logical to expect those valuations to revert as the risks diminish.

All three of those big risks are interlinked, in that they’re not just economic events. They are political economic events, which makes them harder to predict. Politics being what it is, you have a range of possible outcomes. Some of them might not seem likely, or even sensible. But that doesn’t mean it won’t happen. It depends on how the politics operate. So, in Europe, for example, Berlusconi going was extremely important because it gave Germany the latitude to do things that it could not have done if he was still there.  If he comes back, that could cause some problems, though many of the needed reforms are now already in place.

In the US, similarly, the positive is that there is a real possibility that the two major parties will have some form of sensible discussion about the US deficit, albeit, as in Europe, with a lot of brinksmanship, because that’s just the way the world is. Just as the Germans have their constituencies to deal with, the Republicans have got the Tea Party to deal with. That means it could take some time for a clear solution to the fiscal cliff to escape. That’s just the way it is.

In my view the probability of the bad stuff happening diminished last year. Consequently the justification for holding financial instruments whose potential for real returns is minimal diminished with it. Don’t get me wrong. A tail event is still possible, but the politics have moved, individually and collectively, in the right direction. Market prices need to catch up with this new reality.

What about the third tail risk – a hard landing in China?

The outcome there depends a lot on your prior expectations. There was a view for a while that China could grow at high single digits indefinitely. Both arithmetically and economically, that’s just not possible. The power of compounding leads you to some silly numbers pretty quickly. Economically, people forget what economic growth is, which is population growth plus productivity growth. China has had a big productivity uplift from the big movement of people from the countryside to the cities. Once you’re urbanised and industrialised however, any country’s ability to create further productivity gains goes down, and that means economic growth has to go down too.

If you’ve had a mercantilist approach to economics for some considerable time, as China has, and you’ve built up foreign reserves and held down the currency, you will also inevitably get a wage inflation problem in due course. That’s just the natural consequence of having an undervalued exchange rate. Overlaid upon that has been the global financial crisis. China’s huge stimulus response has produced a wave all of misallocated capital, as you always get when you throw money at anything. You get ghost cities and all the rest. I am not sure that they’re something to worry about. You’ve dug a hole in the ground, moved some earth and employed people for a while, but although it has no future productive use and slows down your future productivity and growth, it doesn’t bankrupt you.

The more pernicious issue is wage inflation because it makes you progressively less competitive with the outside world. The employment growth from multinationals putting plants in your area starts to slow. They are faced with 25% compound wage growth. Combine that with concerns over property rights and so on, and the decision where to site their plants becomes less obvious. We’re not there yet in China, but it’s coming. What then comes is a squeeze on profit margins of domestic manufacturers and a squeeze on profit margins for those who have outsourced there.

Why are people still talking up the Nifty Fifty – big companies with proven earnings power and global brands – as the way to invest?

I find that worrisome. If your principal argument for owning such stocks is the precedent of one of the world’s largest equity market bubbles, it should be sending a signal to you that these companies are not obviously cheap! Most Nifty Fifty stocks in the late 1960s got terribly overpriced. These companies are predictable precisely because there are limits on the upside and the downside of what they can earn. That means you’re unlikely to get multiple expansion. You’re only get it through the madness of crowds, and that’s just not a way to protect and enhance your wealth.

Another thing to remember is that, in order to maintain their growth, more of these companies have been going out on the acquisition trail. In some ways, that’s sensible, because they have enjoyed a very cheap cost of capital. Yet the history of companies making acquisitions when the cost of capital was low has rarely been a happy one. If you don’t have the discipline of proper capital costing, companies always end up making acquisitions that don’t make sense.


I am also suspicious of arguments that don’t have any symmetry to them. So Nifty Fifty equities go up because they’re mirroring the bond market – but when the bond market goes down, they should go up again! Remember how in the 1980s investors spent half their time looking at bond to equity yield ratios. If you take a look at these now, comparing either earnings yields or dividend yields to the bond yield, they’re off the charts! It is true in the UK and Japan (Figure 7) and the same in all the other geographies too.

Whatever period of history you look at, or whatever market, the current equity/bond yield ratio is three or four times the historic maximum. The old valuation metrics are being disregarded. Just as cyclically adjusted p/e’s were ignored when they appeared to give a highly unfavourable view of equity valuations in the late 1990s, now history is repeating itself for bond markets.  Nobody pays attention any more.

Where does Japan fit into all of this?

The final big economy of the world has decided to adopt the same policy as all the others! Japan ironically, is probably the one economy for which that policy is appropriate. Why? Japan has had almost zero nominal growth for years, but because of deflation has still seen positive growth in real terms. If it now gets real growth plus inflation, a lot of the issues start to dissipate. That’s why the market has rallied. Although the rally looks like a big move, it’s a tiny move in the context of what’s come before.  Mind you, I don’t think Japan would have performed as badly if you’d not had the tsunami. That’s less because it destroyed productive capacity, and more because it caused the yen to go up and postpone some of the things that are beginning to unfold now.

The things that unfold now could be quite explosive. The big difference is, you’ve got Japanese companies on low single digit profit margins, where the profit margin could double or triple, and you’ve got, if you just take the US, companies whose profit margins can’t go up any further from where they are. The gearing to improvement is all in Japan. It’s very cheap if they get the margins up. Compare that to the US, which doesn’t look expensive based on historic numbers because of where margins are, but if you normalise them, that margin comes down to the historic average at some point, it will look expensive.

Remember that there’s no country in the world whose listed companies could make money if their currency went up every year. People forget, Japanese companies have suffered, or did suffer, almost a 50% appreciation against the Korean won in a three year period. Can you imagine a US or UK manufacturer still being in business if their principal competitor had a 50% cost advantage on them on a three-year period? It’s not that Samsung, a stock we own, hasn’t done fabulously well and isn’t a great company, but it has had some help from the currency working so much in its favour.

In general then the message is: be careful?

Yes. Outside the US, equity valuations relative to long-term history with comparable environments are not that bad. They’re not great, but they’re not that bad. They’re not screamingly cheap. The problem is that bonds are screamingly expensive. Although you will always get dislocations in equities, you can probably expect to get five or six percent real growth. But on your bonds, you’re probably going to get five percent negative.

The other piece is that the corporates have been holding back on capital expenditure. They’ve begun buying small and mid companies as bolt-ons, and the step after that is to spend a bit more, because they’re going to get into productivity issues if they don’t. We’ve already seen underneath the radar screen, quite a lot of corporate activity. That will continue. It will bid up prices and, as you say, nothing gets the animal spirits in the market going more than a bit of fee income. With some of the capacity reductions in the cap-ex industry, when the big companies go to try and increase their capex, they may find they can’t do it quite as quickly as they would like. You may well get a bit of producer price inflation coming through.

None of these things are helpful for bond markets. Within equities, it’s all about making sure you get the right risk/reward balance. If you think that buying bonds allows you to say “I can sleep at night,” you may find that when you awake in a number of years time that, at best, a substantial proportion of your purchasing power has been eroded, and at worst there has been a sharp drop in your capital value. That capital protection you were so keen on turned out to be a bad dream.

Thank you, Sandy.

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