20th July 2015

Investing in the right place

That men do not learn very much from the lessons of history is the most important of all the

lessons of history.

- Aldous Huxley.

Wise man, Huxley. The financial markets are now brimming over with examples of cognitive

dissonance. Observers in the West gaze in disbelief at the $200 billion provided by Chinas state-

owned banks to help prop up their equity markets. Those same observers are either blind to the

trillions of dollars, pounds and euros that have been printed by western states to help prop up

their bond markets or they choose wilfully to ignore them.

Attitudes to the protagonists in the euro zone debt crisis are similarly conflicted and wildly

illogical. The Germans are widely perceived to be the bad guys, and the Greeks somehow

innocent victims of some kind of coup. But it is the Germans who have been virtually a lone voice

in Europe warning of the risks of unsound money and credit expansion. It is only the Bundesbank

and its diminishing number of hard money advocates in Europe who have fought to keep Mario

Draghis ECB from abandoning sound money principles altogether.

A rich vein of unreality runs through the capital markets of 2015. The word unhinged barely

does them justice. Doug Noland does an excellent job of chronicling the confusion. On the one

hand, financial market participants hang on every word of our monetary policy-makers in anticipation of a tightening in interest rates fully seven years after the financial crisis reached

fever pitch. On the other, there is barely any debate over the efficacy of allowing the most

important price in the market, that of money itself, to be controlled by a small, private banking

cabal. As Doug Noland shrewdly observes,

..a promoter of asset price inflation sacrifices its capacity to be an effective financial regulator.

It is all very well to identify the problem(s): too much faith in central bankers and not enough faith

in free markets to direct capital to its most productive ends. But investors also require some kind

of solution, some means of protecting their capital from the more injurious actions of monetary

policy agents and guiding it towards more profitable havens.

The crowning irony of the current financial situation is that policy makers in conjunction with

regulators have made traditionally safe assets the most unsafe investments of any. Western market

government bonds no longer offer any attraction either in terms of income or capital

preservation. They are simply instruments of confiscation yet to be fully recognised as such.

http://creditbubblebulletin.blogspot.co.uk/2015/07/weekly-commentary-lessons-of-2004.html

That clearly leaves equities as the preferred risk asset, by and pardon the inadvertent but

relevant pun default. But what sort of equities ?

History offers some useful clues.

James OShaughnessy in his book What works on Wall Street conducted extensive research on

common stocks in the US market. Perhaps the most compelling strategy for delivering attractive

long term returns came from value investing.

OShaughnessy analysed a 3,000 stock universe over a period of 52 years. For each year he

identified the 50 most expensive and least expensive stocks by a variety of metrics. He then

rebalanced that 50 stock portfolio each year, ensuring that only the most and least expensive

stocks were retained. The results were instructive.

If you had bought the 50 growth stocks with the highest price / earnings ratio, for example, after

52 years, a portfolio with an initial value of $10,000 would have grown to $793,558. That sounds

like a decent return. Until you compare it with a portfolio comprising the 50 stocks with the

lowest price / earnings ratio. This value portfolio, with an initial value of $10,000, would have

grown to $8,189,182.

If you had bought the 50 growth stocks with the highest price / book ratio, the results were even

more extraordinary. Your initial $10,000 would have compounded, over time, to $267,147. But if

you had bought instead the 50 value stocks with the lowest price / book ratio, a portfolio with a

starting value of $10,000 would have grown, over time, to be worth $22,004,691.

A period of 52 years is a statistically meaningful period of time. The OShaughnessy study strongly

suggests that over time, value completely trumps growth. A bias to value may not work every

year, but its unlikely that any strategy will. Value investing requires an element of patience, not

least because it has much in common with contrarian investing, and it takes time for the crowd to

appreciate, or be taught at its own expense, that its wrong.

But the problem today for the conventionally minded is that many traditional markets are

expensive. The US stock market, for example, currently accounts for over 56% of the MSCI World Equity Index. Anybody benchmarked against the MSCI World is obligated to own US

stocks to a greater extent than those of any other market. Robert Shillers cyclically adjusted price

/ earnings (CAPE) ratio for the S&P 500 index currently stands at 27.3. On a CAPE basis, the US

stock market has only realistically been more expensive twice in history once in 1929, and once

in early 2000. Its long run average is 16.6.

Not all stock markets are as expensive as those of the US. Roughly 70% of the US market trades

on a price / book ratio, for example, above 2 times. Roughly 40% of the Japanese stock market

(which incidentally accounts for just 8.7% of the MSCI World Equity Index) trades on a price /

book ratio of less than 1. So it should hardly be a surprise to learn that within our own fund, for

example, Japan is our single largest country exposure. Or that Asia accounts for the majority of

our holdings. Asia, by comparison with Europe, we would suggest, has, on average, superior

demographics, superior prospects for economic growth, a far lower welfare burden, and a

healthier banking system. At a time when headlines are dominated by the travails of the euro zone

and a deeply indebted West more generally, the real investment news is quietly been made

elsewhere.

Tim Price is Director of Investment at PFP Wealth Management and co-manager of the VT Price Value

Portfolio (www.pricevaluepartners.com).

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