Everything has beauty, but not everyone sees it – Confucius
During the months of August and September, the proverbial wall of worry suddenly looked too steep for many investors’ comfort level thereby prompting an en masse retreat across the market. From our perspective though, we find a less crowded wall much easier to climb. Each nook, cranny, and toehold is easier to see, and the entire path upward towards the summit moves into sharper focus.
In many ways, today’s market represents the latest chapter in an ongoing trilogy of macro obsessions. First, it was U.S. credit and the consumer, then it was southern Europe’s credit with the fate of the EU hanging in the balance, and now it is near-term growth in the emerging markets and its credit implications (being further complicated by U.S. Fed policy). To be fair, each scenario has been complex and warranted some concern. This time is no different.
We believe what makes the current investment environment nerve rattling to so many investors is the coupled decline in Chinese economic growth and global commodity prices. During the past fifteen years the two phenomena of steady Chinese economic growth and rising commodity demand (and prices) walked hand-in-hand. Now that commodity prices have drastically reversed course, investors interpret collapsing commodity prices as having deeply pessimistic implications for the Chinese economy, and perhaps other economies and their aggregate demand. We accept the premise that China’s turn away from investment led growth is a negative for industrial commodity prices. However, we find the corollary that lower commodity prices carry such a negative read-through for the Chinese economy in the years to come as an over-simplifying and shakier heuristic. We see the Chinese economy as ships passing in the night, with technology and knowledge-based firms racing ahead, while the old State Owned Enterprises (SOEs) face slow growth or decline. We believe share price volatility created an opportunity to spot bargains in the former, but less so in the latter. Still the fact remains that the coinciding presence of slowing overall Chinese growth—which is a necessary byproduct of its government’s changing policies—and declining commodity prices have augmented uncertainty and confusion in the market regarding near-term prospects. Given this fear, the idea that the Federal Reserve might increase interest rates in this environment only serves to fan these flames of uncertainty towards five alarm status.
We believe when facing such near-term uncertainty, employing a long-term perspective is not a tagline, it is a necessity. On this matter, history provides some evidence. In depth research (Super-cycles of commodity prices since the mid-nineteenth century, Bilge Erten, Jose Antonio Ocampo) into commodity super-cycles suggests that there have been four commodity price super-cycles dating from 1865-2009. If we look at the two super cycles prior to the current one dating from 1932-1971 and 1971-1999, and then take the respective peaks of those markets in 1951 and 1973 as signals to sell equities, investors would have missed out on compounded returns in the S&P 500 of 11.38% from 1951-1971 and 13.94% from 1973-2000. We consider these annualized equity returns to be attractive, and note that they coincided with commodity price collapses of -43.3% from 1951-1971 and -52.5% from 1971-1999. In sum, we believe that the presence of falling commodity prices possesses little predictive value for equity investors. Importantly, this same study suggests that falling commodity prices reflect weakening aggregate demand with a six year lag. With that said, we do not believe the observation that global economic growth stalled six years ago in 2008-2009 is a revelation.
[drizzle]What may be something of a revelation though, or perhaps just something often forgotten, is how infrequent corrections (such as this most recent one) and bear markets tend to appear in an investor’s lifetime. Also worth noting is the relatively small historical decline these events represent in comparison to the market gains that have followed. In the illustration below produced by Morningstar, we can see a tidy summary of these events over the past forty-years in the S&P 500.
Bearing all of this in mind, we viewed the past few months of unsettling volatility and declining share prices as an opportunity. In our view, it was a better opportunity than the magnitude of the declines suggested with losses of only -12.4% on the S&P 500 and -14.9% on the MSCI ACWI, respectively. The reason we believe the correction represented a better opportunity than usual is owed to the unmitigated correlation between share prices across the various spectrums of the market, whether that be size, quality, or industry. These are the same correlations that have plagued stock pickers and active managers over the past several years, but as share prices fell, we believe this phenomenon became a bargain hunter’s best friend. Normally, we would expect quality companies to fall less in price during a correction, as this has been the case in historical market environments, and so the ability to purchase new positions in quality, growth oriented businesses was a pleasant surprise.
Spotting specific bottom-up opportunities always requires some work, but during the most recent correction it became clear that China was the primary source of market uncertainty and therefore, nearly any business with ties to the country or the emerging market consumer found it shares being unusually punished. With that said, we adhered to Sir John Templeton’s timeless advice of searching for bargains where “the outlook is most miserable” and based on the news headlines, and rapid share price declines that place appeared to be China, in our opinion.
In the case of a panic, correction, or even a bear market, we focus our initial research process on enterprises in a strong competitive position and possessing attractive long-term secular growth opportunities. The benefit to this strategy is that a competitively positioned, growing firm’s near-to-medium term returns on capital have a better probability of being maintained at attractive levels. This in turn may lead to higher compounded returns for shareholders over time, as capital continues to be invested, and returns are realized, all things equal. In most cases this means temporarily eschewing the stereotypical low multiple valuation businesses that are often associated with value investors. These latter businesses are more often tied to a mean reverting investment thesis. We also favor these bargains very much, but find that these businesses are often already on sale prior to a market correction, and are just as likely to remain so following the market’s recovery. Put differently, the window of opportunity is less likely to slam shut as market sentiment rebounds. With that said, we also found opportunities during the sell-off in energy and agribusiness firms, but we will be discussing those ideas in a follow-up commentary. Returning to China, we found that the sell-off and ongoing discontent surrounding the country’s near-term economic growth rate drove share prices in both the internet search firm Baidu, and the e-commerce firm Alibaba down to attractive levels.
At first blush, these firms and their valuation multiples may not be the most obvious choices for a bargain hunter. The key here though is how the multiples compare to future potential growth, and as we alluded to earlier some probing beyond the superficial P/E multiples is often necessary.