6 minShould we still be buying equities?
The last few weeks have been miserable for equity investors – the Euro Stoxx 50 index, for example, has slumped by 30% since 1st July. Whereas at the start of 2011, equity indices seemed set to return to their pre-2008/2009 crisis level, now some are even in danger of dropping below the levels seen at the very depths of the crisis.
Added to the recent slide in share prices is the fact that the longer term performance of the markets is hardly more joyful. At the turn of the century, the German DAX was hovering around the 7,000 mark. Some 12 years later, the index stands at 5,100. In France, the CAC 40 is a full 50% below its end-of-1999 level. In the United States, the S&P500, which has held up considerably better than the European indices this summer, is still trailing by 20%. Even people who were prepared to accept that an investment in equities needed a horizon of several years are starting to find that time is indeed long and reflecting on John Maynard Keynes' quote that in the long run we are all dead. So should we still be investing in equities?
Before answering that question, it is worth reminding ourselves what a share represents. There are two ways for a company to finance itself – by borrowing or by issuing shares. The issue of shares represents equity, while borrowing (debt securities) represents external capital. Shares are fundamentally different from debt securities in that they represent a stake in the company. Shareholders are co-owners of the company and the return on their investment depends on the company's future results. Holders of a debt security (generally a bond) issued by that same company are merely simple creditors and only concerned by the future progress of the company insofar as it affects the company's capacity to pay the annual interest and repay the principal at maturity.
Accordingly, anyone contemplating buying shares in a company should be asking the same questions as someone considering acquiring the entire company. Such questions will inevitably revolve around two issues: quality and valuation.
- In terms of quality, does the company in question have attributes that differentiate it from the competitionand enable it to achieve higher margins and generate greater profitability?
- In terms of valuation, can the company be bought at a reasonable price, in other words at a sufficiently low price (in relation to its capital, assets, current and future profits etc.) in order for the investor to be able to expect a sufficiently high return given the risks incurred?
For listed companies, there is also a psychological component to be factored in. Share prices go up and down, often bearing no relation to what is actually happening at the company. (I am always astonished to note that some 10 million Coca-Cola shares are traded every day when, in the majority of cases, there is no major news involving the company. Why did investors who didn't want to buy/sell Coca-Cola on Tuesday suddenly want to do so on Wednesday? I still haven't found an answer to that one...) Investors purchasing a stake in a private company don't have this problem. They need only concern themselves with the operational side of the company and are not faced with a market telling them – in the form of a rise or fall in the share price – whether they were right or wrong.
Daily fluctuations in share prices may frighten investors but they can also offer opportunities. Benjamin Graham illustrated this using a character he called ‘Mr Market', who Warren Buffett often mentions to his shareholders. The story goes like this: imagine that you and Mr Market are partners in a private company. Mr Market comes to see you every day and gives you a price at which he is prepared to buy your share in the company, or sell you his. The company's results are relatively stable but the price that Mr Market offers you swings to extremes. The reason for this is that Mr Market is emotionally unstable. Some days he is wildly optimistic and can only see the positives. On those days, he tends to offer you a very high price. On other days, he is depressed and pessimistic and can only see a future clouded with problems. So the price he offers you then is very low. Mr Market also has another interesting personality trait: he perseveres and doesn't mind if you reject his offer – he's always back the next day. Whether a transaction takes place is your call. It is therefore extremely important not to let yourself be influenced by Mr Market's mood and not to fall under his spell. You are only interested in his wallet, not his views.
The story of Mr Market may seem rather quaint in the modern world where investment is often presented as something complicated and mysterious, with stupid theories about efficient markets, and where computer programs often take precedence over good judgement in decision-making. But the truth is that nothing has changed: buying quality assets at a reasonable price remains the best recipe for a successful investment over the long term.
However, there is another very important lesson in the Mr Market allegory. You can only take advantage of his mood swings if you are better at valuing your company than he is. I am often surprised by the number of people who buy shares in a company without the least idea of what the company is worth. But you can't take advantage of a particularly low or high share price unless you have a benchmark to establish that the price IS very low or very high. At BLI - Banque de Luxembourg Investments, we call this benchmark the company's intrinsic value. Without such a benchmark, you are totally exposed to market uncertainties, with the risk of you yourself becoming Mr Market.
It might seem obvious that people would want to buy quality companies at reasonable prices. But it's not quite so simple in practice. The dot.com bubble at the end of the 1990s is one of the best illustrations of this. Newly created companies not making any profits (even in some cases not generating any revenues) suddenly had enormous stock market capitalisations while other companies were completely side-lined despite posting solid results. For a manager, this poses a very real problem: yielding to a trend under market (and often client) pressure or persevering with a strategy that makes good sense, with the risk of losing a lot of clients who reproach you for ‘being out of touch with the market'? At BLI, we have also adopted another Warren Buffett saying: ‘You don't need to be more intelligent than other people, you just need to be more disciplined.' In the end, you get the clients you deserve.
So to get back to the original question, ‘should we still be buying equities?', the first consideration is that the question is too vague. After all, nobody would think of asking whether we should still own companies. Yet, as indicated above, buying a share in a company means becoming a co-owner of that company. (But note that this is only true in countries where the rights of shareholders and, particularly, minority shareholders, are protected.) Despite the risk of recession or the European crisis, you see very few entrepreneurs ditching their companies, and certainly considerably fewer than investors offloading their shares (remembering of course that for every seller there is a buyer). Moreover, unless you are obsessed with stock market indices, buying ‘equities' or ‘the market' doesn't mean anything. It would be better to rephrase the question as follows: ‘At current share prices, is it possible to find quality companies with a sufficiently low valuation as to offer a reasonable prospect of an attractive return over the medium to long term?' The ‘medium to long term' part of the question is significant. ‘Buying quality companies at reasonable share prices' is not a formula to gain lots of money quickly. Numerous studies have shown that over the short term (less than a year), there is no correlation between valuation and return. A quality company purchased at a low price could become even less expensive in the short term, which generally means a fall in its share price.
The answer to the rephrased question is yes.
