ClearBridge Value Trust commentary for the third quarter ended September 30, 2015.
“Nothing any good isn’t hard.” – F. Scott Fitzgerald
Memories of painful experiences are often a critical and adaptive part of living, in that painful memories can keep you out of harm’s way by minimizing repeat mistakes. The challenge, however, is that memories are highly subjective, and with the passage of time you often forget how intense something felt at the time.
In the realm of physical pain, my biggest outlet for stress is training and competing in triathlons with my wife and several colleagues from ClearBridge. They are all better than me, which is painful enough, but I often don’t have enough time to fully prepare for the longer events. This inevitably leads me to swear off competing again, until I ultimately find myself standing in a cold body of water at the beginning of another grueling physical experience. In all seriousness, I love competing, and the rewards of doing so from a health and emotional perspective far outweigh short bouts of physical pain that are soon enough forgotten.
On the other hand, the pain that investors frequently encounter as they navigate the vagaries and complexity of financial markets is a different beast altogether. In fact, as the great behavioral psychologists Daniel Kahneman and Amos Tversky detailed with the concept of myopic loss aversion: investors feel the pain of losses at roughly twice the magnitude of comparable gains. To make matters worse, investors typically check their performance and evaluate their portfolios frequently, almost guaranteeing a steady stream of short-term emotional pain.
Unfortunately, the potential for short-term pain was extremely high during the recently concluded third quarter. The S&P 500 Index was down over 6%, which was the worst return since the third quarter of 2011. In many ways the key behavioral challenge, and ironically the opportunity, of this entire market cycle is that it started with the acute pain of the Great Financial Crisis (GFC). During the GFC, many stocks dropped to levels that rightly reflected the existential risks of another great depression, as investors grappled with frozen credit markets and a debt-driven deflationary spiral. These extreme initial conditions have been followed by smaller but nonetheless painful deflationary storms: the first Greek exit risk (2010), the loss of the U.S.’s AAA credit rating (2011), Eurozone breakup risk (2012) and last year’s Ebola scare. During this quarter’s deflationary storm, market fears centered on risks of an Emerging Market (EM) crisis, driven primarily by slowing growth in China. To be sure, these are all real risks: deflation and debt is a particularly toxic brew for risk assets, and the probability of an EM-driven credit event has clearly risen.
What these recurring storms highlight is that hits to investor confidence from the GFC and subsequent storms have resulted in a razor-thin level of commitment to equities, and declines in stocks are viewed through the lens of risk and pain and certainly not opportunity. Furthermore, the price volatility associated with myopic loss aversion is exacerbated by the evolving structure of markets. This evolution has further shifted the ownership level and decision making from individual securities and their specific fundamental and valuation characteristics, to classes and sectors of assets that are characterized by the correlation and volatility of their returns. This is most succinctly captured by the notion of equities as clusters of “risk assets,” which can only be safely owned during “risk-on” markets. Price is paramount and deterministic, valuation and increasingly fundamentals are secondary at best!
At this point, you may be asking where is the opportunity amid these recurring waves of deflationary pain and compression of individual stocks into risk-driven clumps. As valuation-driven managers, we
gauge opportunity at both the broad market and individual stock level by assessing the underlying value proposition, and specifically the potential for exploitable price-to-value gaps.
ClearBridge Value Trust – Monitoring the Equity Risk Premium
Starting at the broad equity market level, we try to measure opportunity by constantly monitoring the Equity Risk Premium (ERP), which is the expected excess return from equities over the risk-free-rate (typically the yield on the 10-year Treasury note). To be clear, whether you try to measure the ERP using historic excess returns or by calculating potential forward excess returns, ERP is never a perfect measure of reality. However, measures of ERP that are made consistently through time do generate valuable relative comparisons that can help to robustly answer a key question: what level of investor sentiment is reflected in equities at a given time?
In Exhibit 1, we show ERP as calculated by Professor Aswath Damodaran, a valuation expert and finance professor at NYU. What the exhibit shows is a love affair with equities that occurred during the great bull market of the 1990s, and subsequent equity bubble, which ended very badly during the GFC. Since peaking at 7.68% during the crisis, each deflationary storm has caused spikes in the ERP to levels that are historically elevated. Essentially, investor confidence in stocks has remained at persistently low levels relative to history, with investors demanding elevated risk premium to take on the potential pain of stocks. From our perspective as long-term valuation managers, this persistent investor skepticism towards equities has been a major tailwind for this market cycle. Yes, it may just suggest good relative returns for equities versus potentially over-valued bonds, but it also suggests that the classic investor arc from fear to greed that characterizes every risk cycle should be elongated.
At the individual stock layer, the marginal shift in market structure to frame stocks as correlated clusters is resulting in periods of indiscriminate selling of individual stocks. Frankly, it is much easier to sell a single exchange-traded fund (ETF) to reduce “risk” exposure, than hitting the sell button several times after weighing the merits of each security. As these shifts in asset allocation preferences roll through, the shifting tide of sentiment results in increased stock-level volatility. The volatility is exacerbated by liquidity differences in the underlying securities, which can cause sizeable dislocations between price and underlying value. If you can do valuation math, it can really pay to discriminate!
Besides some basic valuation math, however, you also need time. Post the GFC, and certainly during all these risk-off storms, pair-wise stock correlations have spiked. This simply means that individual stock price action gets even less differentiated during fear-driven sell-offs, as the glue hardens stocks into buckets of gross risk. As a result, correlation spikes can make stock picking a fool’s errand in the short to intermediate term. However, differences in fundamentals and valuation at the security level do matter tremendously over time as panic recedes and stocks inevitably unstick. This is the essence of time arbitrage for long-term investors that pick stocks.
Finally, besides math and time, you also need a strong constitution to turn myopic loss aversion into long-term opportunity. Even though every market cycle is different, and market structures are always evolving, our glaciallyevolving brains struggle to adapt to these rapid changes. In particular, our brains frame the world through stories, and especially causal narratives. In markets, people typically form these narratives through price action, and when stocks are going down most investors cannot rest until they form