Equity markets are currently in a position that has been absent for much of the last five years: high-quality names are starting to look quite expensive. Across the board, the Johnson & Johnson (JNJ) and Coca-Colas (KO) of the world are starting to grow into earnings multiples above 20x, implying levels of growth that in some cases exceed what they’ve managed to put together in the previous decade. At the same time, long-term bonds continue to be priced for limited real returns, which has irked individuals who have watched equity markets continue to run higher.
Collectively, that leaves us with few good alternatives; what is an investor to do in such times?
Luckily for us, James Montier of GMO recently penned an article in the firm's second quarter letter that addressed this; while he offered four potential paths that one could follow, I would like to focus on the fourth option - Be Patient:
This is the approach we favour. It combines the mindset of the concentration “solution” – we are simply looking for the best risk-adjusted returns available, with a willingness to acknowledge that the opportunity set is far from compelling and thus one shouldn’t be fully invested. Ergo, you should keep some “powder dry” to allow you to take advantage of shifts in the opportunity set over time. Holding cash has the advantage that as it moves to “fair value” it doesn’t impair your capital at all.
Of course, this last approach presupposes that the opportunity set will shift at some point in the future. This seems like a reasonable hypothesis to us because when assets are priced for perfection (as they generally seem to be now), it doesn’t take a lot to generate a disappointment and thus a re-pricing (witness the market moves in the last month). Put another way, as long as human nature remains as it has done for the last 150,000 years or so, and we swing between the depths of despair and irrational exuberance, then we are likely to see shifts in the opportunity set that we hope will allow us to “out-compound” this low-return environment. As my grandmother used to chide me, “Good things come to those who wait.”
This idea is so logical, which is probably why it’s hard to follow when markets move into a territory that approaches absurdity; as foolishness continues to grow and market valuations consistently breach new levels (with commentators there to justify this new found optimism), the fear of being left behind becomes overwhelming. We see this exact phenomena with Isaac Newton during the South Sea Bubble (as captured in a 2009 article by MIT professor Thomas Levenson):
Starting at £128 in January, the price for South Sea securities rose to £175 in February and then £330 in March. Newton kept his head - at first. He sold in April, content with his (quite spectacular) gains to date. But then, between April and June, share prices tripled, reaching over £1,000 ... which is precisely when he could stand it no longer. Having "lost" two thirds of his potential gain, Newton bought again at the very top, and bought more after a slight decline in July…
The bubble burst, and South Sea share prices collapsed to roughly their pre-bubble level. Newton's losses totaled as much as £20,000, between $4 million and $5 million in 21st century terms…After the disaster, he could not bear to hear the phrase "South Sea" mentioned in his presence. But just once he admitted that while he knew how to predict the motions of the cosmos, "he could not calculate the madness of the people."
I have a solution for dealing with the madness of people, and my conclusion won’t come as a shock to Gurufocus readers: Continue to be patient if you cannot find securities that meet your criteria. Although it appears that cash becomes an increasingly expensive alternative to equities as markets roar higher, the reality is the exact opposite; future rates of return are being sacrificed for current gains, a trade-off that acts like a rubber band as its stretched further and further from equilibrium (only to come shooting past balance to the other extreme at some point down the road). Those who fail to recognize this undeniable truth are most susceptible to becoming its ultimate victim.
Johnson & Johnson provides an interesting example: When Johnson & Johnson (NYSE:JNJ) was trading at a low-teens multiple of free cash flow for the better part of the last five years, the constant barrage of short-term issues promulgated by the analyst community (and the financial media) were more than priced in. With the stock more than 50% higher than where it traded 24 months ago, the analysts are now lining up with “buy” ratings, proclaiming that the Medical Devices & Diagnostics segment is now out of its doldrums because of “solid growth” attained in the most recent quarter (which was a paltry 0.5% after accounting for the addition of Synthes), and that the Consumer segment is finally getting closer to something resembling normal operations (which was never particularly important to JNJ even during the good years, at roughly 10% of the company’s total operating income).
To be clear (for those who will question this once they come across the disclosures at the bottom of this article), I still own some Johnson & Johnson; this is the other side of “be patient” that receives less attention than it should. Many people live in a state of absolutes marked by decisive – and what I consider to be extreme – action: It often comes in the form of metrics (like a P/E or EV/EBITDA multiple) which are cut-offs that dictate when investors buy and sell (lately, leaning towards the latter). The result, as I see it, is often a narrow window (if we view market movements over a period of years) that rigidly dictates frequent activity.
While this approach is intellectually pleasing (in theory), I don’t think it meshes with reality; one major shortcoming of this rules-based strategy is a failure to look at the whole picture (when I say failure, I don’t mean by construction; it comes from the biases that individuals bring into the picture, which must be considered). Portfolio decisions must be made with an eye on one’s financial situation, in addition to one’s current holdings.
To use myself as an example, I’m young and will be a net saver for decades to come; every month or so I add about 2% in my portfolio in the form of cash (savings), which will be moved into equities once I’m given the opportunity to do so. Year to date, those opportunities have been nonexistent. I have not bought a single share of common stock, and as of today have no plans of doing so in the foreseeable future. As a result, my cash balances have built up a bit; I have plenty of dry powder at my disposal despite the fact that I was fully invested a few months ago.
With that said, I have not sold a single share of stock; I continue to hold JNJ and PepsiCo (PEP) in full, despite the fact that their future returns have been diminished by their recent moves higher. When would I sell? That’s a tougher decision, but it’s one I’m increasingly comfortable making as prices move beyond their current range; in order to part with businesses that I consider above average, I demand a price that adequately captures that fact (as well as the consideration that realized gains and the subsequent tax bill diminish the attractiveness of the alternative); for people with a short term view, who’s returns are solely dependent upon revaluations from Mr. Market (and account for a large percentage of daily market volumes), this isn’t a consideration.
With a view extending more than 10 years, a 20% to 25% move in the equity indices higher or lower is inconsequential; patience should require investors to think in this manner when adjusting equity allocations as individual names (particularly those of above-average companies) move to levels that point towards undue optimism. As Montier’s grandmother used to say, good things come to those who wait. For investors waiting with businesses that consistently generate outsized returns on invested capital, I believe good things justify waiting longer than may seem prudent otherwise.
About the author:
As it relates to portfolio construction, my goal is to make a small number of meaningful decisions. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with a handful of equities accounting for the majority of my portfolio (currently two). In the eyes of a businessman, I believe this is adequate diversification.