The tyranny of the benchmark

“There can be few fields of human endeavour in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.” – J.K. Galbraith (A Short History of Financial Euphoria, Viking, 1990)

As markets rise there is a tendency for investors to assess their investment manager against a selected index benchmark over increasingly short time frames. The fear of missing out on recent returns is psychologically difficult to bear and as a consequence investors shorten their time horizons to focus on meeting or beating this index benchmark over shorter time spans. For most investment managers the implication is clear: perform worse than the benchmark over 12 months and risk losing the client.

However, is this the best way to achieve superior returns over the long term? The answer is a clear “no” for many reasons, two of which are worthy of further discussion. Firstly, assessing investment performance over short periods has an unintended consequence of introducing short term career risk. Such career risk encourages managers to be quasi indexers, hugging the benchmark to ensure no substantial underperformance, and by default no substantial outperformance either. Keynes was right when he said that “it is better to fail conventionally than to succeed unconventionally”.

The second issue to consider is that of absolute vs. relative. Relative investors buy individual securities because they are at lower valuations than their peers. As a consequence, relative value investors will always be fully invested, even when all investments are expensive and offer low returns. Given that most of the time markets are rising (they have a tendency to rise slowly and decline quickly) it is psychologically more comfortable to be a relative investor as this should produce the longest periods of keeping up with a rising index, regardless of valuation.

In today’s easy money environment, such relative thinking has significant implications. With cash currently earning next to nothing, it is tempting to look at equities favourably as the better asset on a relative basis. On an absolute basis, however, global equities are starting to under-price risk, including the risk of not enough earnings growth to support current valuations over the medium to long term. More importantly, over the medium term, cash has “option value.” However, by ignoring absolute valuation, relative investors can enjoy the party right to the bitter end.

There is a price to be paid for such psychological security. As can be seen from the chart above, an investor that “owned” the S&P 500 could have sold at any point in 1998, 1999 or 2000 and been able to buy back cheaper in the subsequent market decline. Equally, the investor could have sold at any point in 2004, 2005, 2006 or 2007 and again been able to buy back cheaper. The relative investor, by being fully invested right at the peak, suffered the severe declines wrought by an overvalued market finally falling.

The absolute investor on the other hand would have been reducing exposure to overvalued equities during 2006 and 2007, perhaps finding some unloved and undervalued areas of the market or holding more cash. Most likely he would have not kept pace with the market rise in its later stages. It is only after the market has declined that the absolute return investor is vindicated. Prior to that point he has to suffer the ignominy of short term underperformance to an index benchmark. However, long term results do not lie and the list of long term top decile performers is dominated by investors who have an absolute return mindset. In fact, one of the most crucial components of generating long term outperformance (and shared by almost all investors in the top decile over the long term) is preventing permanent capital loss. Continuing this line of reasoning, protecting capital in a downturn should hence be a more important benchmark for the long-term oriented investor. Fortunately, our clients understand this.

Of course the key to being a successful absolute investor is the ability to assess absolute value in a long term context. This is not easy with variations in earnings growth, inflation and risk free rates over time. However, valuations are the building blocks of investment so it is important that the absolute investor has a clear view as to what constitutes value. One often forgets that the single most important variable that determines the total return from an investment in any asset at any point in time is the purchase price. Buying without sensitivity to valuation is, to our minds, too close to speculation. Consequently, we strongly believe that our absolute return mindset is fundamental to our long term performance and will continue to operate with patience and conviction to protect and grow our clients’ capital.

Turning to the present, what should be made of absolute values today? Before considering the Veritas view we can look to other “real return” based investors who publish their assessment of the absolute “value” of the market. GMO has a particularly accurate track record in long term forecasts and recently published their forecast for real (i.e. inflation adjusted) returns for the next seven years. They forecast that US large cap will deliver an annualised real return over the next seven years of -2% (yes, that is a minus!) and that ex-US international large cap will deliver an annualised real return of +2%. If they are correct then we have pretty meagre returns to look forward to from the index huggers.

When we look across our universe of high quality companies, the average annualised total return we expect over the next five years (not inflation adjusted) is c. +6%. This is a little more optimistic than GMO and can largely be explained by the skew to quality. Moving away from the “market” to focus on individual companies, it is becoming increasingly difficult to identify good quality companies that are available for purchase at levels that should produce attractive rates of return over our investment horizon. The few companies that we are finding to invest in are typically under short term pressure with negative news flow leading to short term investors selling and providing us with an investment opportunity given our longer term horizon.

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The Allan Gray-Orbis Global Equity Feeder Fund remains fully invested in global equities. The objective of the Fund is to outperform the FTSE World Index at no greater-than average risk of loss in its sector.