Ardevora Quarterly Review – Third quarter 2017

A load of old bulls

Stocks are peculiar investments. They can elicit peculiar feelings. They can provide a source of income (although many don’t), but this income is unpredictable, variable and only of secondary importance to the experience of owning a stock. Stocks are uncomfortable. The discomfort comes from their lack of predictability; stock prices can go down. When you buy a stock you don’t know what its price will do while you own it. It isn’t governed by rules which give you clarity. There are no natural laws which will drive a stock price to a predictable end point, even some of the time. Compare this to bonds or cash. Almost all of the time you know the price of your bond or cash will be either par (for a bond, if you hold it until maturity), or the same as you put in (if it’s cash). No one, as far as I am aware, buys a stock believing its price will fall. Hence, stock market investing is about finding stocks that will go up.

The price of a stock, like anything else, goes up when more people want to buy it than sell it. Markets are stunningly simple in this respect. What is complicated is what makes people want a stock more in the future than in the past (a prerequisite for a rising stock price). The art of investing resides in this complexity: attempting to predict what will prompt others to buy, rather than sell. Our approach to this conundrum is to ponder the behaviour of three groups of people: company managers, financial analysts and investors. All have views about what the future might look like. Understanding how these views can unfold and react with each other, in our view, gives some insight into how stock prices may move.  Ultimately, of course, it is only the shifting views of investors that matter to stock prices. So why bother with the other two groups? Because their behaviour can create events which investors often react to; investors don’t operate in a vacuum.

In some sense we think a stock price’s tendency to move up (or down) is a combination of two forces. First, predicting events that investors should care about (like surprisingly good profits). Second, predicting how investors might react to those events.  The second might sound a bit perverse, but other investors’ prevailing views are not always easy to decipher. Just being able to predict what will happen next (to a company’s profits for example) is not enough to predict what stock prices will do.

At first, it is tempting to believe everyone thinks like you. So when you first come across someone who doesn’t, suddenly the world is inexplicable. For most of us this happens early in life, yet most of us refuse to learn and still find it baffling when someone else doesn’t like our bright blue running shoes. This is the first lesson of investing – you have no insight into how other investors will behave without hindsight; you must use inference, unprejudiced by your own views (of how you would behave in the same circumstances). This presents a dilemma. If you think you know what will happen to a company, but you don’t know what other investors are expecting, how do you know how the stock price will react? Ideally, you would like to ask everyone before the event, “how would you react if?”, but you cannot. You have to rely on something else. Understanding of cognitive psychology and the role of bias can help. In particular, the way anchoring and representativeness exerts influence on people’s judgment.

In our view, investors’ predictions are strongly influenced by their experience, especially experience containing vivid, but potentially misleading, anchoring events. Investors attach too much weight to such experiences as a basis for confidence or anxiety about what could happen next. Stock markets are a great viewing platform for this. They provide plenty of potentially misleading anchors for judgements, and their inherent unpredictability always creates the potential for drama, confusion, misjudgement and error.

The further 2008/09 recedes into history, perhaps the harder it is to recall how exceptional that period was for stocks. Yet it provides such a powerful anchor and it represents what could go wrong if you own stocks at the wrong time. Also, it exerts a perverse influence the further it drifts into history: setting the start of the period when stocks have gone up, a ticking clock for how old the current “bull” market has become. Investor publications often get ageist and zoomorphic about periods of generally rising or falling stock prices. It is believed that older bulls are more likely to shapeshift into bears. The theory is, the longer it has been since stock prices fell violently, the more confident investors become, and the less they notice risk. There may be something in this, but the severity of 2008/09, along with the sheer diversity and breadth of modern stock markets, may distort perception. There is an arbitrary definition for a “bear” market: when a stock market index falls by more than 20% from its high. Under this criterion, we have not had an anxiety inducing episode since 2008. But as a myopic stock picker, it feels a bit different.

2008/09 was truly horrendous. At some time between the last quarter of 2008 and the first quarter of 2009, every major regional stock market index was down by more than 20% from its trailing 12 month high.  Stock market indices are averages.  They can understate what it feels like as a stock picker.  At a stock level, over 90% of stocks were more than 20% from their year’s high during 2008/09 – the pain was widespread. Further, more than half had lost more than 50% of their value – the pain was deep. As a stock picker, it hurts when a stock is more than 20% below its high within 12 months. It really hurts when they halve. It is a strong reminder of the unpleasant unpredictability of stocks.

On the face of it, stock markets have been trauma free since. The US market has stayed within 10% of its high. Europe had one month when it was 11% from its high. The Japanese market had a couple of separate months marginally more than 10% from its high. Emerging markets got a bit duffed up in 2011 (16% away from their highs). But down in the world of individual stocks, life has been a good deal more unsettling.

As stock pickers, there have been two years we particularly remember. In 2011, when emerging market indices flirted with becoming a bear, there was a lot of stock specific trauma everywhere. In the US, despite the market index remaining within 10% of its high, by late 2011 around two thirds of stocks were more than 20% from their respective highs, and one in fifteen were down by more than 50%. It was similar in the rest of the world. Two thirds of Japanese stocks were down by more than 20%, 10% more than halved. Two thirds of European and emerging market stocks were down by more than 20%, one in seven more than halved. I remember at the time that 2008 still loomed large; the fragile nature of the recovery spooking investors on the first sign of disappointing company profits. However, this was not the only anxiety anchor after 2008.

We have written before about the invisible recession of 2016. Most stock market indices “struggled” in 2016, some gained, some lost, but only Japan briefly backed away from its high by more than 10%. But stock pickers got walloped much like 2011. In the US, Japan and emerging markets, early 2016 brought a lot of pain: around two thirds of stocks were more than 20% from their highs, and around one in eight stocks were down by more than 50%. Only Europe was relatively unperturbed (only 40% of stocks were more than 20% from their highs). Our point here is that investors who pick stocks have been reminded twice since 2008 how unsettling the stock market can be, most recently in 2016. Each time this happens, and we ponder the future, 2008 looms large. The bull doesn’t feel very old.


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Previous Commentaries

Quarterly Commentary Period ending June 2017
Quarterly Commentary Period ending March 2017
Annual Commentary Period ending December 2016
Quarterly Commentary Period ending September 2016
Quarterly Commentary Period ending June 2016
Quarterly Commentary Period ending March 2016

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