What can we learn from a Century of Stock Market Returns?

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Legendary investor Charlie Munger, famed for his role at the helm of Berkshire Hathaway alongside Warren Buffet, died at the age of 99 on 28 November 2023. He would’ve been 100 years old on New Year’s day.

The stock market experienced 5 major crashes during his lifetime, the Great Depression being by far the worst, during which the S&P 500 lost 80% of its value. He also lived through World War II and the Cold War, inflation and high interest rates in the 70s, the internet bubble, the housing bubble, numerous recessions, COVID-19, and so on. Think of some of the major events and crises that have taken place over the last century. Think of the newspapers, headlines, breaking stories, predictions, etc. Think of the advances made in technology, medicine and other fields. Think of how much has changed, even things we regard as being constant, like national borders… And that’s just the last 100 years. What might happen in the next 100?

The Lasting Impact

The investment world, especially the media, places a great deal of importance around daily happenings. Every day there’s a story important enough to make the front page, significant enough to cause many people to make major long-term investment decisions. These stories drive a lot of volatility in the stock market, which in the short-term is all we see. But over the long-term these stories come and go, and so does the volatility.

What really matters is profitability compounded year after year. $100 invested in the stock market (S&P 500) on Charlie Munger’s birthday – 1 January 1924 – would’ve grown to nearly $2.2 million dollars over his lifetime. A return of 10.5% per annum, despite all the craziness of world events during that time. That’s the lasting impact of the stock market over the last century.

The Next Century

It seems unlikely that the next century will be any less chaotic or more predictable than the last. The stories that dominate our thinking today will likely fade with the passage of time. But the discipline of investing in good businesses at good prices for the long-term is likely to leave a tangible impact that outlasts any of these stories. There will be plenty of volatility along the way, even a crash or two, but don’t let these things deter you from consistently doing the basics well. Don’t let the news sway you from your long-term investment plan.

“If you’re going to invest in stocks for the long term or real estate, of course there are going to be periods when there’s a lot of agony and other periods when there’s a boom. And I think you just have to learn to live through them. As Kipling said, treat those two imposters just the same. You have to deal with daylight and night. Does that bother you very much? No. Sometimes it’s night and sometimes it’s daylight. Sometimes it’s a boom. Sometimes it’s a bust. I believe in doing as well as you can and keep going as long as they let you.” — Charlie Munger (2021) 

Return-Free Risk

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When you think of government bonds and their role in your investment portfolio, you typically think of stability. You invest in the stock market for high returns, but the bond market for stability. Bonds are there to ‘reduce the risk’ of your investment portfolio, and for that many are willing to accept lower returns. This paradigm has failed investors miserably in the last 3 years as interest rates globally have been hiked at record pace.

According to Bloomberg, US 10 Year Treasury Notes have crashed 46% since March 2020. That’s on par with the worst stock market crashes since the Great Depression! In the last century, US treasuries have never delivered more than 2 consecutive years of negative returns, and even then never of the magnitude witnessed since 2020. This truly is an historic market crash. What makes it even more incredible is that no-one outside of the investment industry seems to be talking about it. If it was the stock market or real estate it would be front-page news by now. I say this tongue-in-cheek, but it’s somewhat refreshing for an equity portfolio manager to watch a market crash from the sidelines.

Risk ≠ Return

There is an important lesson to be learned here. It doesn’t matter how high the quality of an asset is, how consistent the cash flows are, or how creditworthy the issuer may be – if the price you pay becomes completely detached from reality, then the asset becomes very risky. What’s worse is that this risk is associated with low returns, even under optimistic conditions. This stands in contradiction to the common (and inaccurate) mantra that risk = return. Higher business risk may typically be associated with higher potential returns, but the higher risk that comes from overpricing an asset is always associated with lower return.

Consider that in 2020, 10 Year Treasuries were yielding just 0.5% p.a. At that yield you’re not thinking about return, you’re all-in for downside protection. Ironic that 3 years later you’ve lost 46% with virtually no interest payments to cushion the blow, while the stock market (which you were fleeing) has climbed ~80%. One of the reasons Treasuries have never done so badly before, even though they’ve been through some extreme rate hiking scenarios, is that interest rates were already high enough in past hiking cycles to offset most of the capital losses. What you lost in capital you gained in interest. Not so when interest rates are close to zero. Can you see how this crash was built into the price?

Implications for the Stock Market

So what does this mean for the stock market? It’s not entirely clear since stocks are affected by many variables besides interest rates. Unlike bonds, future cash flows are not fixed. Higher inflation means higher revenues for companies, but it also means higher expenses, higher financing costs and, at least in theory, lower valuations. I say in theory, because it may also just mean that the relationship between bond yields and stock market earnings yields (the inverse of Price/Earnings Ratio) have finally normalized after more than a decade of being disconnected. We’re used to thinking of stock market valuations in terms of PE ratios and bonds in terms of yields. If I told you the S&P 500 would trade at a PE Ratio of 200x (more than 10 times historic norms), you’d think I was crazy, yet that’s the equivalent of what US Treasuries were doing in 2020. Just because bond yields have normalized from insane levels doesn’t automatically mean that stock market valuations must drop too.

We are beginning to see the effects of more than a decade of extremely loose monetary policy unwind. What has caught so many off-guard is how quickly loose monetary policy has unwound. We saw signs of the inevitable strain in the first quarter of 2023 with the US Regional Banking Crisis. Now we’re seeing it in the longer dated government bond markets across the developed world. Such a drastic change, to something as fundamental as interest rates, cannot take place without the ripple effects being felt throughout the global economy.

For us as equity portfolio managers, we continue to avoid over-indebted and over-valued stocks, which are most sensitive to fallout from higher interest rates. The biggest risks to be avoided in every kind of investment portfolio are always those that come from excessive leverage and extreme overpricing. Investors may have been willing to overlook these risks in zero-interest rate world, but we believe that’s likely to change.

‘Gradually, then suddenly.’

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The biggest story of the 1st quarter was the collapse of Silicon Valley Bank (SVB) and the ensuing regional banking crisis in the US. It took just two days for SVB to collapse after the announcement that they needed to raise capital. Depositors lost confidence in the bank, triggering a run on deposits and cementing SVB’s fate. This followed news that crypto bank Silvergate was closing its doors. Then Signature Bank, roughly half the size of SVB, was also shut down by regulators that weekend. This sent shockwaves through the broader regional banking industry with the shares of banks like First Republic and Western Alliance down 90% and 60% respectively since then. Even the shares of financial services giant Charles Schwab have lost 35% in the wake of SVB’s closure.

So how did this happen? As Ernest Hemingway would say, ‘Gradually, then suddenly.’

‘Gradually…’

The seeds for the present regional banking crisis were already sown in the 2008 financial crisis. To prevent the technical insolvency of the banking industry, regulators changed an accounting rule which allowed banks to carry certain assets at their original book value instead of their prevailing (and much lower) market value. These assets were marked as ‘held-to-maturity’. The idea was that if the banks could hold these assets until they matured several years later, they would ultimately realize their book value, so they needn’t recognize the sizeable losses they were carrying in the meantime. This didn’t do anything to change the underlying reality of what those assets were worth at the time, but it did mean that the banks could satisfy regulatory requirements for capital adequacy without raising fresh capital. This accounting stroke of the pen apparently worked…

Fast forward to 2020 and the COVID/lockdown crisis. The US administration flooded the market with trillions of dollars of stimulus, resulting in a wave of new deposits for the banking institutions. Deposits held with Bank of America (by way of example) jumped from $700bn to $1.2tn between 2020 and 2021 – an increase of 70% in 1 year. What do you do with all this excess cash in a zero interest rate environment? Apparently you invest it in longer-dated ‘held-to-maturity’ securities with interest rates marginally above zero and pocket the difference. This is risky, since any increase in interest rates would decrease the value of those assets, only not on paper since they were marked ‘held-to-maturity’. This is what almost every US bank did with the wave of stimulus-driven deposits that came their way. Almost all of it was invested in longer-dated securities.

‘… then suddenly.’

The unprecedented stimulus, combined with global supply-chain upheaval in 2022, led to resurgent inflation and consequently the fastest interest rate hiking cycle for decades. When interest rates go from 0% to 4% in a year, something must give. The market value of these ‘held-to-maturity’ securities decreased by ~20% in some cases. If these losses were reflected on bank balance sheets, their equity would be severely impaired.

This brings us back to Silicon Valley Bank: Between 2020 and 2021, SVB’s deposit base more than doubled. Virtually all the new deposits were invested in longer-dated ‘held-to-maturity’ securities. In 2022, roughly 45% of their balance sheet was invested in these longer-dated assets (vs 20% in 2020). This is 2x-4x more than most other banks. Add to this that SVB had a very narrow deposit base, focused on the flagging tech startup space, and you have a recipe for collapse. As cash strapped tech startups began to withdraw deposits, SVB was forced to liquidate a portion of their ‘held-to-maturity’ assets at a sizeable loss to meet the withdrawals. This in turn impaired their capital, hence the need to raise new capital, which spooked depositors… and that was the end of SVB.

Finally…

While SVB was in the most precarious situation, there remains an underlying solvency issue with the overall US banking system. If every bank were suddenly forced to realize the losses on their ‘held-to-maturity’ assets, there would be serious implications. While regulators have managed to stem the immediate liquidity crisis (which exposes the underlying solvency issues), it remains to be seen whether time will take care of this problem or not. Either way, US banks have taken a big misstep which cannot simply be waved away because an accounting rule allows them not to reflect it in their financial reports.

In our portfolios we have limited exposure to the US banking sector. We are avoiding exposure to institutions with large ‘held-to-maturity’ exposures, even larger institutions such as Charles Schwab and Bank of America. Finally, when it comes to banks (and insurers) we avoid the smaller regional players since the largest players are usually better regulated and more diversified.

Dollar Relativity

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It’s been a tough year for stock market investors. The MSCI World Index has returned -25.6% in 2022 (measured in USD), on track for its worst year since 2008 and its 2nd worst year since the index started in 1970. ‘Measured in USD’ is an important consideration though – more so than usual – as the Dollar Index has risen 17% YTD. This is one of the biggest and fastest changes in the Dollar Index over the last 30 years. (The Dollar index measures the USD’s performance relative to a basket of major currencies.) The Rand has lost 12% against the Dollar in 2022, less than the 17% change in the Dollar Index. In other words, the Rand has strengthened against most other currencies. The Euro has lost 14% in 2022, the Pound 17% and the Yen a massive 20%.

The following table shows the year-to-date performance of the MSCI World Index (the global stock market) measured in these major currencies and in ZAR.

MSCI World Index 2022
Currency USD EUR GBP JPY ZAR
YTD Return -25.6% -13.5% -9.6% -6.4% -15.6%
America vs the World

What in USD appears to be serious bear market, appears in most other currencies to be a ‘normal’ correction. How you perceive the current market movement has a lot to do with where you live and spend your money. If you’re in America, spending USD, then 2022 has been a bad year. If you’re in Japan, spending Yen, you’ve barely felt it.

The strengthening USD has been a trend since the financial crisis back in 2008. The following graph shows the performance of the MSCI World Index measured in different currencies, adjusting for the countries’ different inflation rates. This effectively measures how the market has performed relative to the cost of living in these countries.

There is a notable difference between the real USD return since 2008 and the real return measured in various international currencies. The difference between USD and EUR/GBP/JPY is far greater than the difference between ZAR and EUR/GBP/JPY. America has diverged from the rest of the world. What this means, in practical terms, is that the global stock market has done a lot less for Americans over the last 14 years than for people living in other countries, including South Africa. Relative to their cost of living, Americans have gained only 40% since 2008, while the British have gained 114%, the Europeans 138%, the Japanese 151% and South Africans 117%.

As South Africans we often think of the investment world in terms of domestic and offshore. This is a big mistake, in part because South Africa represents less than 1% of the world economy, but also because ‘offshore’ isn’t one big homogeneous basket as we so often imagine it to be. For starters there is a major distinction between the United States and the rest of the world. There is also a distinction between developed markets and emerging markets. The world is a big and diverse place.

So what can we take from this? 
  1. For international resident investors (including South Africans), the market movement in 2022 has been less severe than for American resident investors.
  2. We South Africans often measure ourselves in absolute terms relative to the USD, which paints a very bleak picture. While we do have severe domestic problems, if our currency were ranked on an international leaderboard (to borrow golfing terms), we’d be making the cut, not just in 2022 but even since 2008. There are bigger global forces at play than our local issues
  3. Key point: The global investment space is much bigger than America and the USD. ‘Offshore’ is not homogeneous. When you invest globally you are buying an internationally diversified portfolio with various underlying currencies, many of which are cheaper than the Rand. Don’t let one number – the USDZAR exchange rate – dominate your decision-making process when it comes to deciding whether to take money offshore. Consider the bigger picture.

Finally, we are constantly on the lookout for opportunities to invest in good businesses at attractive prices, wherever they may be. We’ve maintained significant USD cash balances throughout 2022. We’re well-positioned to take advantage of further market weakness. Far from being a disaster, the current market conditions are finally beginning to offer us a very welcome opportunity to deploy excess cash balances.

Effect and Cause

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The MSCI World index lost 15.7% in the second quarter The ongoing conflict in Ukraine has continued to put pressure on global supply chains and commodity prices. US inflation increased to 8.6%, while the Federal Reserve rate increased from 0.5% to 1.75%. Consensus estimates are for a further 75bps increase at the end of July. There is also talk of a looming recession. So what do these indicators mean for the stock market? As investors, how should we respond to the economic data?

Should we time the market?

For many, the holy grail of investing is to find a reliable leading indicator for the stock market. Let’s say you had $ 10 000 to invest in 1970. Suppose you had a reliable indicator that could tell you in advance whether the stock market would earn a positive return or not in the following calendar year. Your strategy would simply be to hold either stocks or cash for that year depending on the indicator. If this was possible, then today (in 2022) your $ 10 000 would be worth nearly $ 7.3 million. If you’d simply held the stock index your $ 10 000 would be worth $ 800 000. That’s pretty good, but it’s only 1/9th of $ 7.3 million! You can see why the temptation to try and time the market, however futile that may be, is so powerful.

But suppose your indicator was not so accurate. What if it had you switching between stocks and cash a year late each time? Your $ 10 000 would be worth only $ 230 000. (The result would be very similar if you were a year early each time.) If you’re going to try to time the market, you need to be very accurate and herein lies the fatal flaw. An indicator that is a bit too early or a bit too late is worse than useless – it has negative value.

Economic data make poor market indicators

This is why economic data (GDP, unemployment, inflation, interest rates, etc.) are such poor stock market indicators. They’re always late. Yes, there is a causal relationship between the stock market and the economy, but the stock market reflects the expectations of investors looking at the future economic outlook rather than present conditions. The effect comes before the cause! The stock market is a leading indicator for the economy, instead of the other way around, even though the economy is the cause of the stock market’s returns.

A simple analogy is helpful: Roosters typically start to crow before the sun rises. Even though the rooster crows before the sunrise, it doesn’t cause the sun to rise. Instead the coming sunrise causes the rooster to crow. The effect comes before the cause. The rooster is a leading indicator for the sunrise, even though the sunrise is the cause.

Trying to time the stock market using economic indicators is like waiting for the sun to rise and then expecting the first rooster to crow. By the time the economic data comes, you’ve already missed the market move. The stock market is such a leading indicator that by the time expectations of future economic data have changed, you’ve already missed it.

What about other indicators?

So economic data are a no-go for market timing, but what about other indicators? Some clever analysts may run all kinds of back-tests to find indicators that would have been accurate (with hindsight), but the list of successful investors who have built their track records by consistently timing the market is a very short one. Back-tests and reality are worlds apart. The reality is that there simply isn’t a consistently accurate leading indicator that can tell you when the next stock market drop will happen. Despite this, not a year has passed since the last crisis that some prominent investor hasn’t predicted the next one. A broken clock tells the correct time twice a day, but that doesn’t make it useful.

There are however some useful indicators that can tell you whether long-term returns are likely to be high or low. But since even low long-term stock market returns are usually positive, it makes these indicators of little value for market timing. It doesn’t help being right about below average market returns for the next decade, but sitting in cash and earning an even lower return. Time is not your friend when you’re trying to time the stock market. If you’re a long-term investor the stock market is the place to be.

Time horizon vs. timing

The following table shows the history of returns for the global stock market since 1970. The first row of each block shows the annual return for that year. The second row shows the annualized return for the 7-year period ending in that year. While the 1-year returns are volatile and unpredictable, the long-term returns are more consistent. There hasn’t been a negative 7-year return* since the total return data for the MSCI World Index was tracked in 1970.

* Past performance is not an indication of future performance.

Invest in superior businesses through the cycle

So if these long-term indicators aren’t useful for market timing, or even for timing specific stock purchases, then what are they useful for? They can help us identify superior businesses that are priced for superior long-term returns. The strategy is to invest in these types of businesses over the long-term, through the unpredictable market cycle. This means we need to stomach the inevitable volatility along the way and not panic every time the market drops. Instead use these drops as an opportunity to add to your stock portfolio.

The list of successful investors who’ve built their track records this way is a much longer one. People like Warren Buffett spent little time trying to time the market or predict the economy, choosing instead to focus on business valuations, profitability and balance sheets. These are the same factors we focus on at Bellwood.

So what is the best approach to manage the market volatility? Don’t make investment decisions based on economic data. Follow a risk-based approach to asset allocation instead of trying to predict short-term returns and time the market. This means having enough cash and liquidity set aside to meet near-term and contingent liabilities and investing the rest in growth assets for the long-term, through the cycle.

Once you have this strategy in place, the most important thing is to maintain your discipline, especially when markets are falling. Emotional decisions are seldom good decisions. Don’t deviate from your financial plan. We won’t deviate from our investment process.

Inflation, Interest Rates and Stock Prices

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One of the most significant changes to the economic landscape over the last year has been the return of inflation. The US inflation rate has risen to 7.9%, the highest reading in 40 years. US inflation has averaged roughly 2% for the last decade and 3% in the 20 years prior, peaking at 5% in 2008. It remains to be seen whether this spike in inflation is in fact ‘transitory’ or not. Many policymakers seem to be abandoning that view now.

Quantitative easing and sustained easy monetary policy have contributed to the potential for higher inflation for some time. But COVID-related supply chain issues and the Russian invasion of Ukraine are the two most immediate causes. The former has resulted in shortages of various goods and higher shipping costs. The latter has led to a spike in global commodity prices, including energy.

Inflation has a direct impact on what we pay for things. It also has a big impact on interest rates. Most central banks aim to curb inflation by raising interest rates. The theory is that when the economy runs too hot, interest rates can be raised in order to cool things down again, and vice versa. The problem is that interest rates are a bit of a blunt tool when it comes to controlling international supply-driven inflation – such as we are now seeing. Higher interest rates in America have little direct impact on the war in Ukraine or shipping from China. They may dampen domestic demand though.

Nevertheless, it seems likely that central banks around the world will respond with higher interest rates. This in turn will have other implications. Our primary concern is how higher inflation and higher interest rates are likely to impact stocks and other assets.

First, higher inflation means higher costs for companies.

However, since the global stock market represents the bulk of the global economy, it stands to reason that one company’s higher cost is another company’s higher revenue. In aggregate, the stock market tends to pass through the effects of inflation. There may be winners and losers depending on the nature of inflation. Good quality businesses are better able to pass through inflation effects.

Second, higher interest rates mean higher debt financing costs.

Companies which have a lot of debt are likely to come under pressure as interest costs mount. The impact of higher interest rates is not so easy to pass through as inflation. In a rising rate environment, overindebted companies will come under pressure.

The low interest rate environment that has prevailed since the ’08 financial crisis has spurred a wave of debt-funded stock buybacks. Companies have taken advantage of the low interest rates to raise debt at almost no cost. They’ve used the proceeds to indiscriminately buy their own shares on the stock market. This has the dual impact of increasing the leverage of these businesses, while simultaneously creating (artificial) demand for their shares. This pushes their share prices higher. It will be interesting to see the effect of this trade unwinding should interest rates start to bite. Not only will earnings come under pressure, but a major source of buying demand will disappear. Should they need to raise equity in order to pay down debt, the effect will be inverted, albeit in a less orderly fashion.

Finally, higher interest rates mean higher discount rates for assets.

When pricing an asset, expected future cash flows are discounted at a rate (the discount rate) to derive a value for that asset. The higher the discount rate, the lower the value of the asset. Central bank interest rates provide a reference point for all other discount rates. When interest rise, so do the discount rates for other assets, implying lower valuations.

The simplest way to demonstrate this is with a government bond. A bond has fixed cash flows on a predetermined schedule with a defined maturity date. This means that the only variable affecting the price of a bond is the discount rate. Higher interest rates => lower bond prices, and vice versa. For any given yield, you can calculate the bond price. As such, bond prices are usually quoted as a yield (which is the discount rate).

Stocks are a little more complicated. Their future cash flows are highly variable and they have no defined maturity date. This means that the discount rate is just one factor. At one time it may be a dominant factor, and at other times be overshadowed by other factors. All else equal, higher interest rates should lead to lower valuations for stocks, which generally means a lower PE ratio.

Interestingly, small changes in discount rates have the biggest impact on valuations when discount rates are very low (i.e. valuations are very high). This makes highly valued assets more sensitive to changes in discount rates than cheaper assets. (This effect is referred to as ‘convexity’ in fixed income management.)

History shows the relationship between inflation and asset valuations.

Since interest rates tend to follow inflation rates, we’d expect to see an inverse relationship between PE ratios and inflation rates over long periods of time. The last 70 years of stock market history demonstrate a weak inverse relationship between the S&P 500’s PE ratio and US inflation. This weak relationship became a lot stronger during the ‘70s and early ‘80s when high inflation was a major factor.

Source: Bellwood Capital, Bloomberg.

Inflation also impacts other assets.

As we already alluded to, bonds are highly susceptible to inflation. This is because they have no mechanism for adjusting the predetermined cash flows to reflect increased inflation. Should we enter a sustained period of high inflation, bond returns are likely to be poor as interest rates rise and bond prices fall.

Property is somewhat similar to the stock market, but since debt-funding is more prevalent, interest rates tend to have a greater impact.

Inflation obviously erodes the value of cash, although higher interest rates tend to compensate for this. (Unless your cash is under your mattress.)

Gold is considered to be an inflation hedge, but with a lot of volatlity (much like other commodities). Over long-periods of time however, gold fails to match the returns offered by productive assets.

There are several implications for equity investors.

Although high inflation is not a good thing for stocks, stocks remain the best long-term inflation hedge. This is because of their ability to pass through inflation over time. The best ways to mitigate the impact of high inflation on your investment holdings are to:

  1. Maintain a reasonably diversified portfolio of high quality businesses, which can pass through the cost pressures of high inflation;
  2. Avoid over-indebted companies, which may become distressed as a result of higher interest rates;
  3. Avoid over-valued stocks where small changes in discount rates will have the greatest impact on valuations.

These three points really sum up our investment process: Acquire and maintain a diversified portfolio of profitable businesses with strong balance sheets at attractive prices.

Remember, inflation is notoriously difficult to predict. We don’t know if we’re headed for a repeat of the ‘70s/’80s, but we can and should always follow a robust investment philosophy and process.

Overconfidence

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The overconfidence effect is a well-established bias in which a person’s subjective confidence in his or her judgments is reliably greater than the objective accuracy of those judgments, especially when confidence is relatively high. Overconfidence is one example of a miscalibration of subjective probabilities. Throughout the research literature, overconfidence has been defined in three distinct ways: (1) overestimation of one’s actual performance; (2) overplacement of one’s performance relative to others; and (3) overprecision in expressing unwarranted certainty in the accuracy of one’s beliefs. The most common way in which overconfidence has been studied is by asking people how confident they are of specific beliefs they hold or answers they provide. The data show that confidence systematically exceeds accuracy, implying people are more sure that they are correct than they deserve to be. – Wikipedia

September saw markets give up some of the gains we’ve seen in the very strong run since March 2020. The realities of COVID/lockdown related supply-chain issues, quickening inflation and political uncertainty around the globe seem to be finding some acknowledgement in financial markets. There is a heightened sense of apprehension. Most investors we speak to have two questions: 1) What’s next? 2) How should we position ourselves?

“What’s Next?”

COVID and the resultant lockdowns have had a knock-on effect on global supply chains. This has led to shortages in a number of key areas. Shortages lead to price increases. The US inflation rate is currently north of 5%, a level breached only once previously in the last 30 years (mid-2008). The Fed tells us this uptick in inflation is transitory, but inflation is notoriously difficult to predict. Inflation has implications for interest rates, and interest rates for asset prices. There’s also the question of what impact trillions of dollars of stimulus will have on inflation and asset prices, not to mention a host of other issues which further compound the uncertainty of the future.

And that’s really the answer to the question of “What’s next?”: Uncertainty. The future is and always has been uncertain. We don’t know what inflation will do next, nor do we know exactly how financial markets will react. And that’s just concerning inflation. There are many other important factors that we also know very little about.

Contrast this basic truth with what you see daily in the financial media. There is no shortage of pundits brimming with confidence ready to tell you precisely what the future holds. Ironically, you’ll find someone to confidently express whatever you want to hear. Their accuracy is nowhere near their confidence. Of course, the media houses will parade the ‘winners’ who got their calls right in the last round for as long as their credibility lasts. There are always people predicting everything, so it’s easy find someone who got it right after-the-fact. Consistently doing the same ex-ante is a different story.

The reality is that no-one seems to be able to consistently predict the future. And even when we do make correct predictions, markets often don’t react the way we’d have anticipated. This makes prediction-based investing problematic, and prone to error.

“How should we position ourselves?”

When we’re asked the questions “What’s next?” and “How should we position ourselves?” the implicit assumption is that the answer to the second question depends on the answer to the first. But unless you’re able to answer the first question with a high degree of accuracy (vs. confidence), it should have very little influence on the answer to the second question.

Because we don’t know what the future holds, nor how markets will respond to specific events, we need to aim for a robust portfolio that is likely to deliver good results under a wide range of future scenarios, and stick to it. Discipline is by far the most underrated trait of successful investors. In an industry where everyone is ‘clever’, and as a consequence overconfident, discipline is the key to avoiding costly mistakes and achieving consistent results.

The problem is that there tends to be a very large gap between our perceived accuracy (i.e. confidence) and our actual accuracy. This is overconfidence. We need to think soberly about our ability to predict the future.

One of the biggest mistakes that investors make is to reposition their investment portfolios in a major way in anticipation of some future event of which they are confident they know the outcome. Time and time again investors will sell out their portfolios or go all-in on a specific asset/industry/geography, abandoning a sound investment plan and setting in motion a series of behavioural biases that make it very difficult to get back to where they should be. It takes just one big mistake like this to derail a successful investment journey. Now we can always get back on the right track, but it can be difficult, and these mistakes can be costly.

An example…

Let’s say you sold everything in 2016 as RBS suggested, predicting an impending global deflationary crisis. By the end of the year, global stock markets had risen 18%. What now? Do I buy everything back again? If so, on what basis? By this time there’s a good chance you’ve set an anchor around the level you sold. “If the market just gets back to where I sold, then I’ll buy everything back.” So we give it some more time… In 2017 markets climbed another 24%.

This chain of events leads either to a kind of financial depression where you never get back to your target portfolio, or capitulation where you take your medicine and move on. The longer you wait, the more difficult it becomes to swallow the medicine. Granted, you might get lucky, but those stories are the exception rather than the rule. It’s better not to put yourself into this kind of position.

So what does a robust portfolio look like?

A robust portfolio first has the correct asset allocation. This means having enough cash to meet short-term liabilities, and enough risk assets to meet your long-term liabilities. Next, a robust portfolio is focused on high quality assets with reasonable valuations. The portfolio must also be diversified in terms of industries and countries, but not to the extent that quality or valuations are compromised. Finally, a robust portfolio avoids excessive leverage, which triggers liquidation during a crisis.

Any major changes in your overall investment portfolio should aim to draw you closer to your ideal portfolio, not away from it. Once this portfolio is established, do not allow “What’s next?” questions to draw you significantly away from it. If you are going to entertain these questions, keep the changes small. Better yet, if you spend less time thinking about these questions, you’re less likely to make these kinds of mistakes.

Finally, it’s worth remembering that against a backdrop of perpetual uncertainty which included the Great Depression, WWII, numerous recessions, wars, market crashes, inflation in the ‘70s, the tech bubble, the housing bubble, etc., the last century has seen the S&P 500 index grow from 4.4 to 4400, not counting dividends.

 

Difficult Investments

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NetEnt and Evolution Gaming have been two of our most successful investments to date. Both are Swedish companies operating in the online gaming industry (i.e. casino/betting systems). Since we acquired them through 2018/19, they have returned 120% and 370% respectively. As of March however, the performance of these two stocks couldn’t have been more divergent. Evolution held up well through the first quarter. Even at its lowest point in March it had nearly tripled since our original acquisition. NetEnt on the other hand lost nearly 40% during the first quarter, reaching a new low in March, down more than 50% from where we’d bought it.

Despite the dismal share price performance of NetEnt up to March, our process indicated that the stock was priced for better long-term returns than before. We continued to buy shares through the first quarter (though not quite at the low), making it our second largest holding by the end of March. In the three months between 19 March and 23 June, NetEnt rallied more than 250%. (It became apparent to the market that their US expansion strategy was starting to bear fruit). By May, NetEnt had become the largest position we’ve ever held in our portfolios. As we didn’t deem it expensive we decided to maintain our full exposure.

On 24 June, Evolution Gaming announced an all-stock deal to acquire NetEnt. The deal priced NetEnt at a sizeable premium and sent the shares 30% higher on the day. Because of the large position size, NetEnt has made a significant contribution to our performance during the quarter. NetEnt is a good reminder of how quickly things can change in financial markets. We need to be patient when things don’t immediately go our way, and ready to respond when rapid changes do occur.

Difficult investments require discipline

There are some valuable lessons to be learned from NetEnt about how successful investments can play out over time. On the one hand you can have a company like Evolution. Evolution moved sideways for a little while after we bought it, and then just climbed higher and higher. Evolution has been an ‘easy’ investment in the sense that we’ve only ever experienced success from the get-go.

NetEnt on the other hand has been a difficult investment. After two years of investing more and more into the stock, we found ourselves 50% down. Three months later we’re up 120%. Successful equity investments seldom deliver nice consistent return streams like Evolution. Most successful investments involve long periods of volatility – like NetEnt.

What is interesting about these difficult investments is that we often make more money out of them than the easy ones. We may have ‘only’ made 120% on NetEnt (vs 370% for Evolution), but we actually made more money out of NetEnt than Evolution. How? We kept adding to our position as the price came down and prospective returns increased. To do so required emotional detachment and discipline.

Why is discipline so important? Because without a disciplined investment process, our judgement can easily be clouded by emotion. Emotional investment decisions generally lead investors to buy when stock prices are high, and to sell when stock prices are low.

Ownership leads to emotional bias

An investor’s emotional perception of a stock depends on two things: 1) What the share price has done, and more importantly 2) whether or not he owns it. Take NetEnt as an example. In the two years before we bought it, the share price had dropped by more than 50%. We were excited by the opportunity to buy a good business cheaply. We didn’t feel those losses. But then two years later, we were down 50% on our investment – and we weren’t happy about it. The fundamentals hadn’t really changed, but our emotional perception of them had. Why? Because we owned it. If we’d been driven purely by emotions we might have resisted buying more shares, or worse, thrown in the towel and sold out.

Our natural emotional perception of a stock is highly dependent on whether or not we own it, yet this has no impact on the future of the business. These perceptions shouldn’t enter the equation. Let’s imagine for a moment that we held off buying NetEnt two years ago, and we didn’t own the stock in March. We’d probably have been just as excited, if not more excited about the prospects of this investment than we were two years before. We’d be emotionally detached from the losses suffered by NetEnt investors over the preceding four years. That’s how we needed to think about NetEnt in March, even though we did own it and had suffered through some of those losses.

No investment process can stop us from feeling these emotional biases, but a great investment process needs to override them in our decision making and enforce discipline. We need to make decisions as though we don’t own the stocks. We need to ignore the emotional impact that ownership brings to the table. Every time we look at a stock that we already own, we need to look at it through the same emotionally detached eyes that we had before we bought it. That’s what our process does for us.

Red Flags Analysis: Wirecard, Alibaba

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At Bellwood, we follow a quantitative process that ignores popular narratives and makes decisions based on underlying fundamentals like profitability, financial strength and valuation. One of the things that differentiates us from other quants-oriented asset managers is that we subject our portfolios to a more qualitative ‘red flags analysis’ before implementation. So the numbers always tell us why we should buy something. We never buy something for qualitative reasons where the numbers don’t stack up. But while we never buy something that the numbers don’t support, we will at times not buy something that the numbers say we should because of qualitative red flags. For us, the biggest red flags are serious questions around a company’s accounting practices, from credible sources.

Wirecard

We saw a very clear example of this play out in the last quarter. We’ve had Wirecard AG (a German internet payments company) on our watchlist for some time, based purely on the numbers. In May it came onto our shortlist and we discussed Wirecard’s merits: It was profitable, had high growth, a decent valuation, strong cash flows and modest debt – the numbers looked good. So we decided to put it through our red flags analysis. Even a cursory glance through their news history reveals that there have been serious questions around their accounting practices, from credible sources, for some time. As a result, we didn’t invest – an easy decision.

In June, Wirecard announced a $2 billion hole in their accounts. The stock price has since fallen 98%. This type of qualitative red flags analysis is simple and we believe it adds significant value to our process. It’s by no means a guaranteed system, but it does a good job of managing the risk associated with fraud, among other things.

Alibaba

To be clear, we didn’t predict the Wirecard fraud, nor did we know that it would play out so quickly after our discussion. But we did see the potential and we avoided it. There are other examples where there is good reason to be suspicious of a company’s accounting where so far nothing has happened. A good example would be Alibaba. Alibaba has been under a cloud of suspicion since its listing in 2014, though it is making new highs as we speak.

We recognized the ‘numbers’ return potential for Alibaba in 2016, but decided not to invest because of their accounting practices. We would make the same decision today. Time will tell if there is substance to these allegations or not. It’s worth noting that between 2009 and 2018, Wirecard’s share price had increased 50x – but now the price is lower than in 2009.

We sleep easier knowing that the companies we hold aren’t under a cloud of fraud suspicion that might implode at any time. We trust that our clients do too.

Keep Doing the Basics Well

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What a quarter it has been. COVID-19 has abruptly reminded us of the many frailties in our global society. The world seems almost paralyzed by the shock. As bad as the reaction in financial markets has been, it pales in comparison to the magnitude of the real economic pain this virus is causing across the globe, not to mention the widespread fear and the impact felt by those who are directly affected by the illness.

Remember that the world is, and always has been, a scary place. This is not the first time something bad has happened, though every crisis has its nuances. It won’t be the last time either. The nature of the risks we face may change over time, but “do not let us begin by exaggerating the novelty of our situation.” – CS Lewis.

 

We entered the first quarter well-positioned for a pullback in the market (generally speaking – we certainly didn’t foresee the COVID-19 crisis) with ~20% in cash and strong balance sheets across our portfolios. These are the two things you want going into a bear market. We are ready to deploy cash as we see the right opportunities to do so.

It’s at times like these that we need to remind ourselves of the basics and keep doing them well. We’ve highlighted 4 principles that we think are especially relevant to a crisis like this:

Basic Principle #1: Be proactive about asset allocation

To the extent that it is possible, keep enough cash aside to meet near-term liabilities and contingent liabilities. You don’t want to be forced to liquidate large portions of your stock portfolio or other assets in the middle of a liquidity crisis. A focus on asset allocation also reduces the urge to engage in speculations about which way the market will head next, which are seldom profitable.

Basic Principle #2: Beware of leverage

The sustainable return of businesses across the board is going to take a knock during this economic crisis, with a few exceptions. A major factor that will determine which of those recover and which don’t is leverage. A strong balance sheet is the most valuable asset a business can have during a crisis. Overleveraged companies are likely to become distressed and may be forced to raise capital at the worst possible time, permanently impairing the equity of existing shareholders. Financially sound businesses are more likely to ride out the storm and recover.

This has always been a major focus in our investment process. Our portfolios are well-positioned in this regard.

Basic Principle #3: Diversify

This crisis has affected the travel industry more than any other, and it seems unlikely that this will recover in a hurry. Grocery production, medical, pharmaceutical and certain technology companies have been relatively unaffected. Some countries have also suffered worse outcomes than others. Geographic and industry diversification remains a cornerstone of financial risk management.

It is important, however, not to buy overvalued or low-quality businesses for the sake of diversification. Diversify within the constraints of quality and valuation.

Our portfolios are well-diversified on both an industry and geographic basis.

Basic Principle #4: Keep your discipline

The reality is that it’s probably too late to address the first 3 points. They needed to be in place before the crisis hit us. Without a doubt the most important thing to do through the crisis is to keep your discipline. Emotional decisions are seldom good decisions, yet emotion drives markets more than anything else in times like these. Stick to your financial plan. We are sticking to our investment process.

Remember that the shares you own are not merely pieces of paper and numbers on a screen. These shares represent ownership of very real businesses providing very real goods and services. These businesses are more substantial and secure than most of our own private businesses, yet because we are made aware of their market value on a tick-by-tick basis, and because we are detached from their reality, we are more inclined to worry about them and react impulsively.

Traditional economics assumes that we are all rational thinkers, therefore more information makes us better decision makers, but this simply isn’t true. Because we are not always rational, more information can feed our irrationality and make us worse decision makers. This is especially true of financial markets where we are constantly bombarded with information and live prices. Perhaps this even applies to the situation we find ourselves in with COVID-19. Don’t let the deluge of negative information distract you from doing the basics well.