In the 1980s, Stella Artois started an advertising campaign based on their beer being “reassuringly expensive.” The idea that you usually get what you pay for applies equally well to investment as to beer or anything else. Quality always comes at a price.
The opposing concept is “cheap and cheerful” but in investment, “cheap” is not synonymous with “good value” and bargains are often not as good as they seem. With investments, “cheap” often means that there is something wrong that is not apparent at first sight. Fools rush into cheap shares while the wise are on their guard.
Cheapness is usually judged by the price/earnings (p/e) ratio – the multiple of share price to annual earnings per share – or by the price/book ratio – the share price divided by net assets per share. The problem with these measures is that they are too obvious, so everybody can see them. Investors often delude themselves into thinking that they are smarter than the market but as the “wisdom of crowds” concept shows, the many are usually smarter than the individual.
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If an asset is cheap, ask yourself why
If a share, asset class or market is “cheap,” the question should be “what is wrong with it?’ Earnings may be about to fall or the asset value may be over-stated. The business outlook may be deteriorating, the management may be useless or the company’s output on the way to obsolescence. A high burden of debt or extreme competition may threaten bankruptcy.
Often, the more obvious the problem, the better. The challenges may be fully priced in, new management may have a coherent plan to turn the business round or the business environment may be about to improve. Cyclical stocks, such as commodity producers and housebuilders, nearly always look cheap relative to earnings (though not to assets) at the top of the cycle and expensive at the bottom. That encourages investors to buy when they should be selling and to avoid the shares when prices and volumes are about to recover.
This is where a contrarian investor steps in, buying shares that have fallen sharply, which nobody else will touch with a bargepole, despite their cheapness. If successful, huge returns can be generated but it is all too easy to buy too soon. Every business that went bankrupt looked absurdly cheap before it called in the receivers. The successes of a good contrarian strategy should more than outweigh the failures, but it is only the successes that are remembered.
For the “reassuringly expensive” investor, the challenge is the opposite. What justifies a relatively high price? Growth investors will point to research that shows that the persistence and scale of growth is habitually under-estimated. Greg Openshain of Verdad Research disagrees, arguing that “growth is not persistent at all” but “high margins and high returns on capital are relatively sticky, reverting only slowly.” High growth rates will fade but if the company can convert high growth into high profitability, it will continue to be a good investment. This is a lesson that Netflix, Meta and others are now learning.
A good rule for investing in “expensive” shares is “how long do I have to wait for the shares to be reasonable value?” Long term investors should be happy to ride out a year of share price stagnation while earnings catch up, but three years is usually too long. In practice, the share price probably won’t stagnate but a growth investor must be prepared to be patient.
Don’t get carried by market trends
Investors tend to get carried away with a trend in the markets. This caused them to overpay for growth in the late 1990s and in 2021 and disregard “value” stocks. At such times, perfectly sound companies can become too cheap just because investors have their minds focused elsewhere. Similarly, stocks in growth areas (such as technology survivors in the early 2000s, biotech stocks recently) can become too cheap, offering growth plus low valuations. Such phases don’t last so the opportunity in value, but perhaps not in recovery, has already gone.
An example of this may lie in the housebuilding sector, where share prices have collapsed in the expectation of a significant downturn in both house prices and volumes while costs have risen. Yet the price of land will also fall, boosting margins, and interest rates are unlikely to rise by as much as feared a month or two ago. Against this, the margins enjoyed in an oligopolistic sector may prove unsustainable
The prices of natural resources are high which ought to constrain demand and increase supply but, unlike in previous cycles, miners and energy companies have not invested to expand output as prices have risen. It may be too soon to sell, though the hostility of governments and public opinion make them a dangerous long term investment.
Markets can be cheap for very good reasons
When applied to countries, the danger of being attracted to a “cheap” market has been made all too apparent this year. Russia was a cheap, high yielding market until its invasion of Ukraine wiped investors out.
The US is widely regarded as expensive but persistently out-performs. Whatever the short term issues, the culture of free markets, the entrepreneurial spirit, individual responsibility and political checks and balances combined with energy self-sufficiency, scale and the universal currency of the dollar is deeply embedded and makes it “reassuringly expensive”.
The UK is certainly cheap but maybe it is cheap for good reasons. There is a strong consensus across the political spectrum in favour of tax and spend, against savings and investment, favouring the public over the private sector and sceptical of growth. 70% of corporate earnings are earned overseas but corporation tax is rising and the clamour for windfall taxes, for example on Shell, is not limited to UK profits.
Investment trusts, now trading on generous discounts to asset value, are also cheap but are the tax privileges of pension funds, Isas and trusts completely safe? The seizure of pension fund assets has become popular with the left in Latin America, with Argentina, inevitably, the first to do so. A UK government could at least start directing investment to preferred political objectives, such as lending them money, at the expense of returns. Such measures seem very unlikely but a few years ago, they were inconceivable and in a few years’ time may be merely unlikely. That alone merits reduced valuations for UK shares.
There are few bargains without risk. It’s usually better to pay up for quality. That’s where the value really lies.
Max has an Economics degree from the University of Cambridge and is a chartered accountant. He worked at Investec Asset Management for 12 years, managing multi-asset funds investing in internally and externally managed funds, including investment trusts. This included a fund of investment trusts which grew to £120m+. Max has managed ten investment trusts (winning many awards) and sat on the boards of three trusts – two directorships are still active.
After 39 years in financial services, including 30 as a professional fund manager, Max took semi-retirement in 2017. Max has been a MoneyWeek columnist since 2016 writing about investment funds and more generally on markets online, plus occasional opinion pieces. He also writes for the Investment Trust Handbook each year and has contributed to The Daily Telegraph and other publications. See here for details of current investments held by Max.
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