The way we explain our process for managing portfolios has significantly changed over the past few years. It seems that both retail and institutional investors want to hear more about how ‘the sausage is made’ than they did a decade ago. And why not? The financial markets have been difficult to navigate since the market topped in the year 2000 and good consumers want to know how we might fare if the markets remain challenging in the future. While I appreciate the work that has gone into fine-tuning our message, one aspect of our investment process is just as relevant as it was when we started tactically and actively managing portfolios in October 2002: We try to find investment opportunities that have a great story.
For us, a great investment story typically involves fundamentals, market psychology, or traditional valuation – or some combination of the three. (Astute followers of our investment process will recognize these points as the three ways we determine value as a value investor.) One of the trickiest stories to tell has to do with traditional value, because there are trainloads of data supporting the idea that if you purchase a security when it is cheap there is a high likelihood that you will earn above average returns over a long period of time in the future. The problem is that investors reward securities with cheap valuations for a good reason (typically cheap valuations accompany investment stories where there are significant problems with the underlying investment), and markets and individual securities can remain cheap for an exasperatingly long time.
The investment universe is awash in stories that begin with a great value proposition, as defined by low price to earnings, price to book, price to sales, relative performance, absolute performance, intrinsic value, and so on. The key is to find a value story that includes a catalyst that allows you to profit when the rest of the market gets around to seeing the same value opportunity that you do. Value investors are often the most obstinate of characters, convincing themselves that they are correct in their assessment of value and the rest of the market is wrong. It takes chutzpa to win the value investing game. Furthermore, valuation stories often take a long time to play out (and the financial markets delight in letting us know that our analyses is faulty or our timing is wrong). But when you get it right… these stories often offer the biggest gains.
The Dangers of Storytelling
One of the problems with investment stories is that they are too easy to tell to our clients – they make everyone feel good because the narrative always has a happy ending. Americans are aging, so investing in health care companies will be profitable. America is becoming energy independent, so investing in energy companies will be profitable. China has a high rate of GDP growth, so investing in emerging markets will be profitable. Unfortunately, while all of the above may be true, they may not be true in a time horizon that is meaningful for our investors.
In other cases, the cast of characters in our story changes — or the news changes the plot — and then the story doesn’t make as much sense as it once did. Our current “go global” story is a good case in point. In the case of Europe, the story goes something like this: By uttering the words, “We will do whatever it takes” to maintain the viability of the common European currency, Mario Draghi, President of the European Central Bank, changed the investment landscape. While Europe has many fundamental problems to deal with, the fears of a systemic meltdown in the European Union are misplaced. Therefore, European markets offer good value since many European economies are in recession, or are close to recession, and stocks in many countries are trading near their all-time lows (as opposed to the U.S. stock market which is trading right at its all-time high). Investors should buy while there is ‘blood in the streets,’ and Super Mario (as named by our investment team) will save us from any major market collapse while we wait for the excellent value in Southern European countries to be realized.
The problem is that voters in Italy didn’t get the memo and recently had an election with results that frightened those who want to see the austerity measures favored by the ECB carried out. Additionally, the EU has resolved a sovereign bank crisis in the tiny country of Cypress in a way that has also alarmed investors. The net result is that the cast of characters for the Europe story may be changing, and the resulting plot twist may not be to our liking.
Story telling is a great way to explain what we are doing in terms of managing money, but there’s a risk that investors forget that stories can change. Pinnacle analysts are tasked with monitoring every aspect of the stories we invest, and if the story changes, we respond accordingly. For us, these changes are nothing more than business as usual. For example, we are restructuring our European positions and will be selling some to invest in what (to our eyes) represents an even better story.
If you want to know what’s happening in your portfolio, listen to the stories we’re telling, and recognize whether the plot is about fundamentals, market psychology, or traditional valuation. Our next investments will take advantage of one or all of them, and will also have a catalyst to get the prices moving in the right direction within a period of time that is acceptable to all.
The plot thickens….
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