1 December 2024
Beating the game
There is no shortage of comments on positioning your portfolio in the “current markets”. Will Trump’s victory lead to higher tariffs, borrowings and inflation?
Many of the opinions (although not all) are just opinions aimed at making commentators look smart rather than readers rich. There are too many moving parts in the economy to make high-conviction predictions. Besides, markets are forward-looking and already priced in consensus thinking about future events, while most comments explain what has happened.
Earlier this year, I participated in the CFA UK Annual Forecasting event, which asked about a hundred professional investors how they would allocate capital in 2024. The mood among participants was quite cautious. Most participants hesitated to allocate 100% of capital to equities, citing geopolitics and uncertainty over the upcoming elections in the US and a few other large nations.
I know many people who stay away from markets precisely for the same reasons, citing potential issues around elections, political changes and other similar points. These points never seem to go away.
My point is not that the majority at the CFA event got the 2024 allocation wrong. Indeed, a scenario when Kamala Harris won by a narrow margin and Trump refused to accept the results was entirely possible. The main issue is that many people miss out on the best opportunities the market provides by adopting a' worldview' investment approach.
Some very few professionals can win in the macro game, but not the majority.
So, are there better alternatives?
Of course, passive investing, especially based on regular allocation is the best-known alternative which requires little explanation.
Many of the opinions (although not all) are just opinions aimed at making commentators look smart rather than readers rich. There are too many moving parts in the economy to make high-conviction predictions. Besides, markets are forward-looking and already priced in consensus thinking about future events, while most comments explain what has happened.
Earlier this year, I participated in the CFA UK Annual Forecasting event, which asked about a hundred professional investors how they would allocate capital in 2024. The mood among participants was quite cautious. Most participants hesitated to allocate 100% of capital to equities, citing geopolitics and uncertainty over the upcoming elections in the US and a few other large nations.
I know many people who stay away from markets precisely for the same reasons, citing potential issues around elections, political changes and other similar points. These points never seem to go away.
My point is not that the majority at the CFA event got the 2024 allocation wrong. Indeed, a scenario when Kamala Harris won by a narrow margin and Trump refused to accept the results was entirely possible. The main issue is that many people miss out on the best opportunities the market provides by adopting a' worldview' investment approach.
Some very few professionals can win in the macro game, but not the majority.
So, are there better alternatives?
Of course, passive investing, especially based on regular allocation is the best-known alternative which requires little explanation.
Proven Strategy
I prefer another strategy, however, which is a simple bottom-up approach of buying quality businesses at attractive prices. Both definitions – “quality business” and “attractive prices” – cannot be expressed as a single formula. There is an element of subjective judgement, which makes investing closer to art than pure science. Just like in art, practice is one of the critical success factors in investing.
There are many advantages of such an approach. The basic “philosophical” one is that such strategy is fully aligned with the fundamental concept of stocks as pieces of business, where an investor is becoming a partner in a business with daily liquidity being an additional advantage.
Another advantage is less competition, especially if you step out of the most popular segments of the market.
A significant advantage in the context of elections is that truly quality companies generate wealth regardless of the occupants of the White House or 10 Downing Street.
Consider a few companies profiled in the Hidden Value Gems newsletter over time.
Of course, not all HVG stocks have delivered such strong results, with Exor, another conglomerate, being essentially flat this year.
But the overall point remains the same. Rather than focus on what will happen in the next 12-18 months, it is better to find businesses with low downside risks, can grow earnings and are not too expensive. Downside risks are lower for companies with solid margins and low debt, which helps them stay profitable, with no need to raise new capital if their sales drop 10%.
Whether managers are aligned with shareholders and how much they are focused on creating value rather than preparing for the next career move is also a critical factor.
There are many advantages of such an approach. The basic “philosophical” one is that such strategy is fully aligned with the fundamental concept of stocks as pieces of business, where an investor is becoming a partner in a business with daily liquidity being an additional advantage.
Another advantage is less competition, especially if you step out of the most popular segments of the market.
A significant advantage in the context of elections is that truly quality companies generate wealth regardless of the occupants of the White House or 10 Downing Street.
Consider a few companies profiled in the Hidden Value Gems newsletter over time.
- Games Workshop (+49% YTD). The company earns high margins (10Y average Gross and Operating Margins are 70% and 29%, respectively) and delivers 16% top-line annual growth (10Y CAGR), benefiting from a growing loyal customer base and network effects. Its operating margin has expanded from 13% in FY2014 to 39% in FY2024, helped by the economy of scale effect. This has led to an even faster growth of operating profits (10Y CAGR +29%). The company generates lots of cash (over 100% FCF conversion) and runs a net cash balance sheet, returning excess cash via dividends.
- Corpay (+35%). Like Games Workshop, this US-based fuel card and corporate payment solutions provider has an attractive combination of growth and returns, delivering a 10Y sales CAGR of 15% and a 10Y average operating margin of 44%. Its historical ROE has been over 50%. The company has actively repurchased its own shares, reducing the share count by a quarter since 2016.
- Berkshire Hathaway (+33% YTD). The best-known conglomerate running the largest reinsurance operations in the world, a selection of leading private businesses, including one of the largest railways and energy businesses in the US, as well as a large portfolio of stocks and cash. One of the main reasons the stock is in the HVG portfolio is its low downside risks. It is particularly attractive in the current environment as its insurance ‘float’ started earning a higher yield compared to the previous 10 years, while many of its businesses are well positioned to benefit in the inflationary environment.
- Loews (+23% YTD). A less-known conglomerate run by the Tisch family. Similarly to Berkshire, it has insurance operations, an investment portfolio and several private businesses (Hotels, Pipelines and Packaging).
Of course, not all HVG stocks have delivered such strong results, with Exor, another conglomerate, being essentially flat this year.
But the overall point remains the same. Rather than focus on what will happen in the next 12-18 months, it is better to find businesses with low downside risks, can grow earnings and are not too expensive. Downside risks are lower for companies with solid margins and low debt, which helps them stay profitable, with no need to raise new capital if their sales drop 10%.
Whether managers are aligned with shareholders and how much they are focused on creating value rather than preparing for the next career move is also a critical factor.
One more secret beyond quality and price
The hardest part of investing in such seemingly ‘boring’ stocks like Berkshire Hathaway or Games Workshop is not identifying their economic moats or estimating their fair value range. The biggest challenge is to continue holding them when not much seems to be going on, the stock underperforms the market, while valuation seems high.
This happens almost every year. For a bright and ambitious investor, efforts are always associated with results. So, such a person will quickly find more exciting opportunities where the price is lower and there is more than one near-term catalyst.
Patience may be an overused word in investing. But it is indeed patience to wait and not jump to the next exciting opportunity, giving a quality business enough time to grow, which is often critical to investment success.
It is easier to have patience when you know that you are in the same boat as the CEO, who has an exceptional track record and is the company's largest shareholder. It is also easier if you can switch your focus from short-term market movements, daily news and opinions to the long-term.
There is one other reason why holding Berkshire and similar stocks is hard. You cannot impress your friends with such positions. More importantly, if you are running a fund, you will likely struggle to draw attention from asset allocators if Berkshire is your largest position.
Of course, this is not to say that Berkshire will generate the best returns in the future. Far from it, it will likely deliver returns very close to the market, hopefully a little better. With an average Return on Invested Capital of 10% and a “negative cost of float” of 4-5%, it should still be in a good position to generate a 14-15% total return on equity and grow its earnings at that rate, and most importantly, with much lower risk than a typical company.
This happens almost every year. For a bright and ambitious investor, efforts are always associated with results. So, such a person will quickly find more exciting opportunities where the price is lower and there is more than one near-term catalyst.
Patience may be an overused word in investing. But it is indeed patience to wait and not jump to the next exciting opportunity, giving a quality business enough time to grow, which is often critical to investment success.
It is easier to have patience when you know that you are in the same boat as the CEO, who has an exceptional track record and is the company's largest shareholder. It is also easier if you can switch your focus from short-term market movements, daily news and opinions to the long-term.
There is one other reason why holding Berkshire and similar stocks is hard. You cannot impress your friends with such positions. More importantly, if you are running a fund, you will likely struggle to draw attention from asset allocators if Berkshire is your largest position.
Of course, this is not to say that Berkshire will generate the best returns in the future. Far from it, it will likely deliver returns very close to the market, hopefully a little better. With an average Return on Invested Capital of 10% and a “negative cost of float” of 4-5%, it should still be in a good position to generate a 14-15% total return on equity and grow its earnings at that rate, and most importantly, with much lower risk than a typical company.
Is the UK still worth it?
I have written about the UK market several times this year (first here, then here).
The market’s performance has been quite disappointing, especially relative to the US. However, this is the whole point of why it remains even more attractive today. My call is not that the UK will be the best-performing stock market in the next year or two. The point is that finding great opportunities and potential multi-baggers will be easier here than in more competitive markets. The US, for example, has benefited from strong macro tailwinds (or suffered less than other regions, like Europe and the UK, from high energy prices) coupled with investor enthusiasm benefiting from rising earnings and valuation multiples.
Conversely, poor overall performance has led to massive outflows from the UK, often from passive strategies that sell stocks irrespective of their fundamentals or valuation. With less enthusiasm, fewer analysts are actively covering UK stocks, eventually leading to higher market inefficiency.
One of the critical points is that many UK companies generate most of their profits outside of the country. While technically listed in the UK, their exposure to a relatively UK economy is limited.
Trustpilot, an HVG portfolio company I have discussed a few times before, derives 60% of its bookings outside of the UK, with the US being its most important growth driver. The stock is up +111% YTD.
It is not all that bad. Strategic investors have been taking note. Just this week saw three strategic acquisitions.
Mubadala-owned Fortress made a bid for a UK casual dining group, Loungers (+38% in a week, +36% YTD). Aviva announced a bid for a UK insurance business, Direct Line (+50% in a week, +26% YTD). Macquarie made an offer for a UK waste management company, Renewi (+39% in a week, +26% YTD).
This is not a one-week phenomenon. Strategic M&A activity has been elevated for at least two years now.
Moreover, with lower valuation and higher cost of capital, share buybacks are now as widespread as ever, not to mention traditionally high dividend distributions.
The market’s performance has been quite disappointing, especially relative to the US. However, this is the whole point of why it remains even more attractive today. My call is not that the UK will be the best-performing stock market in the next year or two. The point is that finding great opportunities and potential multi-baggers will be easier here than in more competitive markets. The US, for example, has benefited from strong macro tailwinds (or suffered less than other regions, like Europe and the UK, from high energy prices) coupled with investor enthusiasm benefiting from rising earnings and valuation multiples.
Conversely, poor overall performance has led to massive outflows from the UK, often from passive strategies that sell stocks irrespective of their fundamentals or valuation. With less enthusiasm, fewer analysts are actively covering UK stocks, eventually leading to higher market inefficiency.
One of the critical points is that many UK companies generate most of their profits outside of the country. While technically listed in the UK, their exposure to a relatively UK economy is limited.
Trustpilot, an HVG portfolio company I have discussed a few times before, derives 60% of its bookings outside of the UK, with the US being its most important growth driver. The stock is up +111% YTD.
It is not all that bad. Strategic investors have been taking note. Just this week saw three strategic acquisitions.
Mubadala-owned Fortress made a bid for a UK casual dining group, Loungers (+38% in a week, +36% YTD). Aviva announced a bid for a UK insurance business, Direct Line (+50% in a week, +26% YTD). Macquarie made an offer for a UK waste management company, Renewi (+39% in a week, +26% YTD).
This is not a one-week phenomenon. Strategic M&A activity has been elevated for at least two years now.
Moreover, with lower valuation and higher cost of capital, share buybacks are now as widespread as ever, not to mention traditionally high dividend distributions.