Bank crises, (new) themes for 2023, risk and return, and figuring out quality
The best investment research, blogs and podcasts this week
We’re only 10 weeks into 2023 and already the expectations for shares and markets this year are being torn up.
Much of the early predictions rested on tentative views of where inflation and interest rates would go this year. It was those moving parts (and the possibility of recession) that dragged so heavily on prices in 2023.
But the narrative has changed. Talk has switched from hard landings to soft landings and no landings. Now it seems that inflation is stickier than expected, but growth is better. So recession, for now, seems less likely in the near future. Ahead of this week’s UK Budget, the OBR said it was no longer forecasting a technical recession for the country this year.
But that’s not to say there aren’t still big challenges. And, as always, it’s what we don’t know that seems to hit hardest. Enter Silicon Valley Bank (and Credit Suisse (although we kind of knew about that one)).
Last week’s collapse of SVB was a bit unusual. Here was a bank with a client base dominated by venture capital-backed businesses, the founders of those firms and the VCs themselves.
Flush with all that private cash to look after - and apparently SVB’s balance sheet tripled in size during the pandemic years - it piled it into US treasuries.
Problems came when rising interest rates pushed down the value of those investments. With customers withdrawing cash in increasing numbers, signs of stress turned the whole thing into a bank run
In summary, it was a mismatch between depositors withdrawing funds and SVB’s ability to liquidate long-term investments. It looks like terrible risk management on the part of the bank’s executives. US regulators stepped in to fix things before they ran out of control. But to say that markets have spent the week reeling is an understatement.
One of the best things I’ve read on all this is by Noah Smith: Why was there a run on Silicon Valley Bank?
So what is being made of all this?
Higher volatility could present opportunities
Neil Birrell, CIO at Premier Miton, believes we’re at or near a critical point in the economic cycle when stress in the system is high - but that we already know this. He says it’s the unknowns that will likely be the problem:
“For now, those unknowns that have come to light appear to be containable, although they have caused significant volatility and remain a concern.
“It is important to focus on the long term and remember that volatility in the short term can provide very interesting opportunities for active investors.”
That view is shared by Amundi, which sums up events with the view that rising rates are now starting to flush out some of the questionable decisions that were made while rates were so low for so long:
“We reiterate the need to keep a cautious stance on risk assets at this stage, as the vulnerabilities that have built up during the recent rapid interest rate hikes are starting to materialise.”
US shares are set to be weaker
Allianz says it’s softening its stance to US equities (and noted that others are doing the same here):
“This confirms our opinion that we are due for a weaker phase in US equities, especially as valuations remain on the higher side and margins deteriorate.
“This outlook supports our recent reduction in US equities in multi-asset portfolios. Given the rising risk of a financial accident – as borne out by the SVB collapse – we were not the only ones to be positioned this way.”
Private tech company valuations will fall
Janus Henderson says the episode will likely speed up the process of a writedown in valuations of private tech companies (which happened in public tech companies last year). They reckon public tech remains far more attractive now [see below - (New) themes for 2023 - for more on US tech valuations]:
“We continue to highlight the discrepancy between the reset in public technology valuations versus private, the latter having been much slower to take the required write downs. The collapse of SVB likely accelerates that process and we continue to view publicly-listed technology companies relative to unlisted as being much more attractive in valuation terms.
“Investors should also be aware that many technology funds have private exposure that has yet to be properly marked-to-market, which may impact their valuations.”
(New) themes for 2023
Getting back to the subject of themes for 2023 (now that a lot has changed), there was a note from Schroders this week on what to expect through the rest of the year and beyond.
There are 10 themes in total but here are couple of highlights:
Value has much further to run
The Value factor enjoyed a pick up in performance over the past couple of years. That followed a decade between 2010 and 2020 when Growth dominated and cheap shares were really that last thing anyone was interested in.
One of the intriguing things about the recovery of value (especially last year) is it seems to have been partly responsible for the surprisingly stop-start performance of quality stocks.
Quality tends to be a go-to preference in times of economic strain. But it can also be pricey. With value coming to the fore, quality didn’t quite behave as expected in 2022. You can read more about this in a note by MFS here: The Unusual Performance of Quality in the First Half of 2022
That aside, Schroders reckon value is still cheap (see chart below). Assuming value shares adjust back to their historical average, that would result in an 11.8% cumulative outperformance against the market over the next three years.
When it comes to measures of value, they pinpoint dividend yield and free cash flow as the best ways to find recessionary winners (rather than earnings and asset based valuation measures).
US big tech will stay out of favour
Schroders suggests that the big sell off in big US tech has made the Nasdaq a much more balanced index - so buying the entire basket is no longer a winning strategy. That said, tech in the States is still expensive. They reckon the sector currently trades on a forward P/E of 21x, down from 30x last year. But that’s still a 20% premium to the market.
As far as the FANMAGs are concerned, there seems to be less certainty than ever on near-term earnings expectations. Meanwhile the search for the next crop of US tech growth shares continues.
Loosely functioning disasters
I can’t remember whether I stumbled on this by accident or whether someone else mentioned it... either way, there is this quote by the PE investor Brent Beshore that brilliantly sums the reality of what so many businesses are:
The idea that most businesses are “loosely functioning disasters that sometimes make money” rings true. And when you’re dealing with issues of company quality, moats and suchlike, I always think of this quote because it makes you realise how unusual great quality can be.
On this note, there were a couple of articles this week that really tap into some of these questions around quality. The first is by Phil Oakley for SharePad, called: Getting the right balance between risk and return
It’s a super read, but the essence is this:
Many investors shout about their winning positions but rarely reveal how much risk they took to get them
Sometimes those risks can be excessive
Small-caps are popular with private investors but they can be some of the riskiest shares
Over the past five years large-cap indices have done better than small-cap indices
It’s usually preferable to invest in higher quality businesses, which often reveal themselves through their finances
Things to watch for are:
Low debt
Accounts that are free of red flags
Stable sales and profits
Value-add acquisitions
Low short interest
Reasonably priced shares
I mentioned earlier that quality misfired though 2022 because value did so well. But that aside, this chart of the MSCI World Quality Index shows just how strong the factor has been against the wider market for many years (here).
This index basically tracks “quality growth” with a focus on high return on equity, stable year-over-year earnings growth and low financial leverage - so very much in the spirit of Phil’s suggestions.
A final note on quality covers this article from
: Statistically Speaking, You Are The PatsyHe talks about the research of Hendrik Bessembinder, whose studies have found that positive returns from the stock market come from a very small fraction of quoted companies. The truth is that stocks, on average, do no better than government bonds over time.
With this in mind, there is a disconnect between valuing shares using discounted cash flow models (which basically put a valuation on future cash flows many years out), and the fact that many companies simply fizzle out long before those cash flow expectations are realised.
In essence it’s far too optimistic (a classic bias) to model future cash flows in the way that many investors are used to, because business life cycles can be surprisingly short.
Likewise, traditional value investing techniques like to focus on what would theoretically be left over if all the worst things happened and a company was liquidated. How much would be left for the investor? It’s a way of introducing a margin of safety.
Yet the reality is that dying businesses are pretty good at soaking up every last drop of cash flow going. Those last remnants usually find their way to management, employees and creditors - not to investors.
There’s an eye-catching passage in the article that reads:
“…investors bet against all sorts of forces and unforced errors that can kill a company: bureaucracy and complacency, empire building, bad risk management, leverage, and plain old strategic mistakes. Competitive moats, corporate cultures, and customer goodwill built with great effort by generations of employees can be blown up with a few terrible decisions.”
This comes back to Brent Beshore’s observation that most businesses are “loosely functioning disasters”. As an investor, you’re betting that the ones you choose won’t be.
The answer, according to Frederik, is to know what you are buying. You’re either in for the long haul, buying high quality businesses you can live with for a lifetime. Or you’re trading securities and sticking around for as long as those high quality companies stay high quality, and moving on as soon as they start to fade.
Have a great weekend,
Ben
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