‘Activist investors descend on ‘bargain basement’ UK companies’, says the FT headline yesterday, quoting one such investor in Los Angeles. As we are quantitative investors, with a rules-based approach driven by our own measure of market valuation, we don’t normally comment on anecdotal evidence. Stories like this form a large part of the market noise that non-quantitative investors easily mistake for a signal. They also feed investors biases when they support something they already believe.
That’s what I could be doing now, by quoting this. Fowler Drew’s current allocation strategy is significantly ‘overweight’ the UK (in terms of our model’s ‘neutral’ position, if all markets were equally valued). We wrote about this here: The US to UK switch. I’m not sure that a valuation level for the UK about 25% below normal counts as ‘bargain basement’ but, relative to the US (most relevant to activist investors), the gap of about 60% is very unusual. So the story supports our strategy.
The strategy does not need that support and the reason for referring to it is to ask what it implies about our own model. What creates the opportunities we seek to exploit? Are they the same or different at other times or in other places? How does the opportunity come to be validated, in the sense of predicted outperformance actually materialising? Interpreted as a basis for changing our exposures to different countries, how well timed are these changes? How much does timing even matter?
The model is contrarian – that follows from switching from the US which is performing relatively well to the UK which has been underperforming for several years. But, unlike most contrarian approaches, it is not driven by the relationship between price and earnings, dividends or book value. It is driven by real total returns (deflated returns with dividend income reinvested). Implicitly, periods when markets are much above their own regression trend for returns can be rationalised or validated if, after the event, it turns out the growth trend (driven by one or other or all of earnings, dividends and asset values) is higher than it was historically. The markets were not just ‘commenting’ on the current valuation of corporate cash flows but ‘predicting’ a change in sustainable performance in earnings power. Relying on the regression trend is therefore a systematic, repeated bet against implied sustainable changes in earnings power, or long-term growth, and a bet instead on things remaining much as they were. Which bet is most likely to work out?
The evidence is that betting against changes in the trend of real returns has been better rewarded than following valuation measurements that imply and require a change in the trend. Sometimes the valuation measure is itself at fault. Earnings mean different things when accounting rules change. Dividend payout rates may change for reasons that have nothing to do with changes in earnings power. Book values reflect historic not current cost accounting. But these false-data signals are not the reason betting on the trend persisting works well as the basis of a long-term investment strategy. It is simply that big changes have been anticipated far more often than they have in fact occurred.
It is possible to theorise why this should be the case. An explanation could rest heavily on the constraints, such as global competition, that lead to mean reversion in corporate performance, such as for returns on capital. Or it could major on the nature of an equity index, as an artificial construct whose rules-based dynamics have the effect of flattening differences. Either way, theorising is interesting and may for some investors be necessary but empirical evidence could be persuasive enough.
Applying these divergent beliefs to the FT’s story, what is rationalising the under-performance of the UK? Here’s one take on it quoted by the FT, from the head of equities at Schroders, referring specifically to the FTSE 100. ‘A common theme is that many of these cheap opportunities are large, long-term underperforming companies who have faced strategic crossroads.’ The FT lists in a table all the companies in that index that are currently the targets of activist intervention: GSK, Vodafone, Royal Dutch Shell, Pearson, Rolls-Royce, SSE, Aviva and Taylor Wimpey. A lawyer at White & Case’s activist practice describes the characteristics that attract activists (and that the UK is perhaps by its history unusually endowed with): ‘…bigger, conglomerate-like structure that has different business lines and geographies, which are core and non-core.’
The change implied by the poor price performance itself, that would validate it, is that these asserted background factors, whether political, economic or accidents of structure, will have such an impact that the sustainable growth trend of the UK market will be lower. Maybe not permanently but for long enough to affect savers over a lifetime. The observed long term trend of annualised real equity returns being 6.1%, the implied rate is only 4.6%.The investors quoted in the story foresee a different outcome, as they obviously believe corporate performance can be improved by better management and that hidden value can be released by disaggregating corporate assets. A ‘bargain’ does not mean they disagree with the diagnosis, just the outcome. They think achievable investment returns need not decline, even if it is because of their own actions.
To bet against the implied change in sustainable growth you do not need to believe that corporate activism will be what proves you right. You do not need to know what will prove you right. Looking at turning points in absolute and even relative return, of which the data history for many different countries contains a vast number of examples, it may be possible after the event to identify some triggers but they were not predictable.
Which brings me to the final point. Slavishly following relative valuation in a contrarian manner is not a market-timing solution. Exposures change gradually. It may be helped or hindered by a separate solution for timing the changes in exposure, such as one driven by momentum. They all have their own issues and good timing is probably best treated as outside the investor’s control.
If you give up fretting about timing, and looking for signs in stories, you have something instead you should value. If your portfolio allocations are always (yawn) optimal on risk-adjusted excess returns:
- the probable returns or outcomes predicted by the model will be as accurate a basis as you can have for decisions you need to make on any day about how much to save, spend, draw, gift; when to retire; whether to transfer a DB pension
- they will provide a stress-free basis for the portfolio decisions themselves.