History repeats

“The proper behaviour all through the holiday season is to be drunk. This drunkenness culminates on New Year’s Eve, when you get so drunk you kiss the person you’re married to.”

– P.J. O’Rourke.


On May 29th 1969, Warren Buffett wrote to his partners at the Buffett Partnership, informing them of his intention to retire, and wind up the business. The letter expressed his concerns with admirable candour:

“Quite frankly, in spite of any factors set forth on the earlier pages, I would continue to operate the Partnership in 1970, or even 1971, if I had some really first class ideas. Not because I want to, but simply because I would so much rather end with a good year than a poor one. However, I just don’t see anything available that gives any reasonable hope of delivering such a good year and I have no desire to grope around, hoping to “get lucky” with other people’s money. I am not attuned to this market environment, and I don’t want to spoil a decent record by trying to play a game I don’t understand just so I can go out a hero.”

Money managers are not necessarily known for their integrity, and as the fund management profession has become more and more institutionalized, it is unlikely that many practitioners today would have the moral courage to pen similar words to their investors, even if they shared Buffett’s sentiments.

Times may change, but human nature doesn’t. Here is an excerpt from a Financial Times piece published on December 29th 2015:

“Investment guru Warren Buffett is headed for his worst year relative to the rest of the US stock market since 2009, with shares in his conglomerate Berkshire Hathaway down 11 per cent with two more trading days to go.

“The underperformance comes in Mr Buffett’s Golden Anniversary year at the helm, when he told investors for the first time that they should judge his record based on Berkshire’s share price, rather than just the book value of the company, which had been his preferred yardstick for decades.

“Mr Buffett urged them to make that judgment based on the long term, rather than on a single year, reflecting investing mentor Benjamin Graham’s view that the stock market may be a “weighing machine” in the long run, but in the short term it is a “voting machine”.

“But in 2015, the market has been voting negatively on Berkshire’s prospects..”

To paraphrase: “Warren Buffett urges his investors to take the long view, but look at how his stock performed last year !”

Buffett’s decision to shut up shop would be vindicated by subsequent market performance. Between November 1968 and May 1970, the S&P 500 fell by 36 per cent.

Investors in US stocks may be forgiven a certain feeling of déjà vu. Robert Shiller’s cyclically adjusted p/e ratio for the S&P 500 (‘CAPE’) currently stands at a multiple of 26. Its long run average is 16.6. If history is any guide, there are grounds for concluding that the US stock market today is overvalued by roughly 50 per cent. And reversion to the mean may be the most dependable trend in financial markets.

But plausible overvaluation is not limited to the US stock market. Fund managers GMO recently published their 7 year real return forecasts for a variety of asset classes – all of which have been made expensive by unprecedented monetary stimulus and the suppression of natural interest rates. Given current valuations, GMO’s assessment of likely 7 year real, annualised returns from a variety of markets is as follows:

• US large cap stocks: – 2%
• US small cap stocks: -0.5%
• International large cap stocks: +0.2%
• International small cap stocks: -0.8%
• US bonds: -0.9%
• International bonds: -2.7%
• Cash: -0.2%

In terms of traditional assets (stocks and bonds), the only markets GMO expects to do better than international large cap stocks are emerging market bonds (+2.2%) and emerging market stocks (+4%). But if their forecasts are correct, pickings from traditional markets are going to be slim. A question. Are your assets under the control of a conventional manager hoping to “get lucky” with “other people’s money” ?

But then not all markets are created equal.

While the (overvalued) US stock market accounts for fully 59% of the MSCI World Equity Index, private investors are under no obligation whatsoever to replicate the index weights of MSCI. Their portfolio managers, however, may be.

Logic practically compels today’s unconstrained investor to go off benchmark. If traditional markets are expensive by any conventional measure, then it makes sense to look for value in less traditional markets.

Which markets are our favourites ?

Within our unconstrained value fund, our single largest allocation is to Japan, a market which returned 9 per cent for 2015. Notwithstanding last year’s rally, the Japanese market continues to offer up a trove of value opportunities. The absolute number of Japanese stocks valued at less than 10 times earnings, for example, is greater than across the markets of China, the US and the UK put together.

Another significant allocation is to Vietnam, a frontier market making the transition to emerging market status. Its market cap to GDP ratio, at 30 per cent, is the lowest in Asia (Thailand and the Philippines, for example, trade at 116 and 95 per cent respectively). Vietnam has a large, young, technologically literate population and the country is rapidly industrialising. It also has the second lowest forward p/e ratio in Asia, at roughly 12 times, just above South Korea (also one of our larger allocations). Vietnam returned 6 percent for 2015 – the only gainer in south-east Asia.

Warren Buffett wound up his partnership after making the frank admission that the US stock market was sufficiently expensive that he could find no real opportunities for investment. History seems to be repeating itself. The great insight of his mentor, Benjamin Graham, was that if it was possible to buy high quality businesses at a discount to their inherent value, such discounts offered a ‘margin of safety’ to the discerning investor. Traditional assets (stocks and bonds in developed markets, notably those of the US) offer no margin of safety today. But there are plenty of low risk investible equity opportunities with a ‘margin of safety’ out there, provided one can free oneself from benchmark constraints and hunt for value, across the world, on a bottom-up basis instead.

We wish all our readers a happy and prosperous new year.

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