Value Manager Says This Time IS Different

Yesterday’s slightly weaker than expected result from ANZ Bank [ASX:ANZ] took the wind out of the market yesterday. But the ASX 200 recovered before the close to finish down just 6 points. ANZ closed 2.1% lower.

A lower than expected net interest margin was the main reason behind ANZ’s weaker than expected result. It came in at 2%, down from 2.07% in the same period last year.

What is the net interest margin? It measures the difference between what banks pay to access funding and the interest rate they charge customers. Given the recent interest rate increases banks imposed, it’s expected that net interest margins will recover in the second half of the year.

The other point of note to come out of ANZ’s profit presentation is that the housing market isn’t showing any major signs of stress. As the Financial Review reports:

The figures from Australia’s third-largest mortgage lender back up the picture of a home loan market that is steady and continues to benefit from record-low lending rates, even as prices rise. ANZ said the proportion of people paying their mortgages on time stood at 58 per cent, having gradually ticked up from 54 per cent in March 2015.

The proportion of overdue loans was steady at 3 per cent, although the proportion of borrowers with a repayment profile more than three months ahead has ticked lower to 30 per cent from 33 per cent two years ago.

There are a few things to note here. Firstly, while it has improved over the past two years, it’s surprising that only 58% of mortgage repayments occur on time. What about the other 42%!

Given that only 3% of mortgages are overdue and just 1.5% are 30-days past due, it suggests that a large chunk of borrowers are just keeping their heads above water. Or maybe it’s a timing thing? Late repayments don’t necessarily seem to flow through to higher rates of 30 days past due.

Positively, of the 58% of people paying mortgages on time, 30% are more than three months ahead of their repayment schedule.

As I’ve mentioned a few times, with official interest rates so low you’re unlikely to see a sharp rise in mortgages 30-days past due.

But when interest rates start to rise, it will be another matter…

Speaking of low interest rates…

They, and other things, are the source of much soul searching by famous value based fund manager Jeremy Grantham.

In a quarterly investment letter, published yesterday, Grantham laments that things are no longer predictably easy for value oriented fund managers. When he started in the markets in 1965, he said, being a value manager was easy:

For the next 10 years, the out-of-favor cheap dogs beat the market as their low margins recovered. And the next 10 years, and the next! Not exactly shooting fish in a barrel, but close. Similarly, a group of stocks or even the whole market would shoot up from time to time, but eventually — inconveniently, sometimes a couple of painful years longer than expected — they would come down. Crushed margins would in general recover, and for value managers the world was, for the most part, convenient, and even easy for decades. And then it changed.

It changed in 1996 in the lead up to the tech bubble. That is, the price earnings ratio of the S&P500 from 1996 until now averaged 23.36. Compare that to the 1970–96 average of 13.95. In other words, for the past 20 years you haven’t seen a reversion to the mean that was so reliably a mainstay of investment thinking.

You can see this change clearly in the graph below:

Source: Compustat, GMPO

Click to enlarge

So despite all the warnings about overvalued stock prices, the S&P500 is right now sitting right on its 20 year average. Who’s to say it won’t move higher in the years to come?

Grantham puts this structural shift down to a few things. Most importantly, he says that it is due to a sustained increase in company profit margins. In turn, this has been driven by the big decline in real interest rates.

Investors generally pay a higher price (higher P/E ratio) for high margin companies. And on top of this, lower real interest rates produce a higher valuation.

Let me give you a simple example:

Say a company has $100 million in earnings and the interest rate is 10%. Capitalising those earnings gives a valuation of $1 billion.

But if you capitalise the earnings using an interest rate of 5%, the valuation doubles to $2 billion.

But Grantham says that, even so, higher margins driven by lower interest rates should have been competed away. That’s how capitalism is meant to work. But that hasn’t happened.

Grantham says that this is because of increased corporate power (lobbying is an industry), the existence of monopolies, and greater brand power. This led him to a powerful realisation. That is, sometimes things ARE different:

We value investors have bored momentum investors for decades by trotting out the axiom that the four most dangerous words are, “this time is different.” For 2017 I would like, however, to add to this warning: Conversely, it can be very dangerous indeed to assume that things are never different.

Things are always different. The world changes constantly. You have to keep up. The only thing that doesn’t change is human behaviour. It is this constant that will probably see stock prices move into post-1996 bubble territory again.

That is, everyone who has lamented high stock prices over the past few years will eventually ‘get it’ and move into the market, pushing prices back to stupid levels. There will be talk of a new era, or something similar. The hand wringing over how expensive stocks are will subside.

That’s when you should start eyeing the exits. But for now, there are a lot of punters on the sidelines waiting to get into the game. As stock prices move higher, more and more will be sucked in.

And that will keep pushing the market higher. Macquarie bank thinks the ASX 200 will hit 10,000 points in 10 years. My colleague Sam Volkering says you can double that.

To see his ASX 20,000 presentation, click here.


Greg Canavan is a Feature Editor at Money Morning and Head of Research at Fat Tail Investment Research.

He likes to promote a seemingly weird investment philosophy based on the old adage that ‘ignorance is bliss’.

That is, investing in the Information Age means you have all the information you need at your fingertips. But how useful is this information? Much of it is noise and serves to confuse, rather than inform, investors.

And, through the process of confirmation bias, you tend to read what you already agree with. As a result, you often only think you know that you know what is going on. But, the fact is, you really don’t know. No one does. The world is far too complex to understand.

When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases.

Greg puts this philosophy into action as the Editor of Crisis & Opportunity. As the name suggests, Greg sees opportunity in a crisis. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines traditional valuation techniques with charting analysis.

Read correctly, a chart contains all the information you need. It contains no opinions or emotion. Combine that with traditional stock analysis and you have a robust stock-selection strategy.

With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the basic, costly mistakes that most private investors do every time they buy a stock.

To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Money Morning here.

And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here.

Official websites and financial e-letters Greg writes for:

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