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.

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.

Last quarter we wrote about active share and how our portfolios are very different from the index. The strength (both relative and absolute) that we saw in September continued through the end of the year, as our portfolios rose 13.1% in aggregate during the last quarter, bringing our total net USD return for 2019 to 23.5%, while holding roughly 15% in cash.

If in the previous quarter we were reminded of the importance of active share, then this quarter we were reminded of something equally important: Equity returns don’t come smoothly! As of end-August our year-to-date return was only 3.5%.

It’s very easy to lose patience with a stock, an investment strategy or even the whole stock market when returns don’t quickly materialize. So how do we counter this? Is it simply a matter of being patient in every instance? Turns out there’s more to it than that.

Lesson #1: Patience doesn’t pay when you invest in a bad business.

Let’s consider a tale of two stocks – Johnson & Johnson (JNJ) and Ford – two American heavyweights. Between 2002 and 2012, JNJ’s share price changed by… 0%. A decade of no real return. The same was true for Ford. Since 2012 JNJ’s share price has more than doubled, while Ford’s has languished for almost another decade. Following those 10 years of no return, how could an investor distinguish between these two companies? The answer is to break down those returns into their components: Sustainable return and revaluation. Sustainable return is a persistent source of return, while revaluation tends to cancel itself out over long periods of time.

Between 2002 and 2012, JNJ’s real sustainable return was 165%, while its valuation had dropped 60%. Ford on the other hand had delivered negative sustainable return, and its valuation had more than doubled over the same period. To an investor looking back at 10 year total returns in 2012, these two stocks would have looked the same. To an investor looking at sustainable returns and valuations, these two stocks couldn’t have been more different. JNJ is a high quality business with a proven track record of profitability and a healthy balance sheet, both of which drive strong sustainable return. Ford has always been the opposite.

Lesson #2: Patience doesn’t pay when you overpay, even for a good business.

So now we know we must invest in good businesses. But 10 years is a very long time to earn nothing from a good business like JNJ. So how can we avoid waiting 10 years to earn a positive return? Don’t overpay! In 2002, JNJ was on a 32x PE ratio. In 2012 it was 13.7x. Once you’ve determined that something is a good business, you still need to pay a good price for it to ensure good returns.

There are countless examples of high quality businesses that have delivered fantastic sustainable returns since 2000, but have only recently reached breakeven for their investors that were paying ridiculous prices during the tech bubble. It took 15 years for Microsoft investors (who paid 70x PE in 2000) to breakeven, despite the business delivering 430% real sustainable return over the same period.

Interestingly, Ford has traded on a single-digit PE for most of the last 20 years. Valuation on its own isn’t enough – you still need to buy a good business – remember lesson #1.

But what about the medium term? In 2010, JNJ traded on a 14x PE. It was cheap, it was a good business, but two years later it had delivered no return. This is when patience is required. This is when patience pays.

How can we apply these lessons today?

So let’s come back to 2020 and see how things are set up: The US stock market continues to make new highs. Over the last 10 years the S&P 500 has returned 256%. Why not simply buy the S&P 500 today and be patient?

If we adjust for the abnormally low margins of 2009/10 the S&P 500 traded at a PE of 13.5x a decade ago, vs 22x today. Roughly half of the total return of the last decade has come from revaluation from historical lows to the highest PE since the tech bubble – a non-persistent source of return. If valuations revert to anything near their long-term averages, and sustainable returns remain roughly the same for the next decade, this implies low-single-digit real returns from the S&P 500. Furthermore, these returns aren’t likely to come smoothly! Don’t expect the last decade to repeat itself. Remember lesson #2.

We’re far more comfortable holding a globally diversified portfolio of high quality businesses trading at historically low valuations, with 95% active share relative to the global benchmark index.

For many South African investors, the Rand exchange rate is the single most important variable they consider when deciding whether to invest money offshore. It crowds out every other consideration. We think this is a mistake.
If you’re thinking about investing globally, but you’re worried about timing the Rand, ask yourself the following questions:

1) How much of your wealth is focused in South Africa?

This is probably the most important consideration: If you’re overexposed and something goes seriously wrong here, your wealth could be permanently impaired.

This is an emotive topic for many investors and advisors who have strong views about what will happen one way or the other, ranging from doomsayers and fearmongers to the fervent “we’ve always recovered in the past” crowd.

We fall into neither camp, preferring a more probabilistic approach to risk management. Risk events have two elements: 1) Probability of occurring, and 2) magnitude of loss. A failed state is generally a low probability event, but the magnitude of loss is very high. Low probability, high magnitude risks are risks worth managing. This is the reason young, healthy people buy life cover. We think about country risk the same way. Global diversification is a form of country insurance.

Depending on where the Rand is trading, country insurance may be free, cheap or expensive. Free insurance is a no-brainer. Whether or not you decide to pay for country insurance should depend on two factors: 1) Price, and 2) how much insurance do you already have?

So how much of your wealth is focused in South Africa?

If, like many South African investors, you have a local business, a house, a pension and/or retirement annuity, chances are high that most of your wealth is focused in South Africa. If most of your liquid, discretionary assets are also invested locally, paying a fair premium for some country insurance might not be such a bad idea.

If, on the other hand, you are a global investor with very limited exposure to South Africa, your mindset is totally different. You have become the insurer, and for you it may make sense to be moving in the other direction, collecting premiums in exchange for bearing country risk as part of your globally diversified portfolio. This is a good position to be in.

Discussions about how cheap South Africa and the Rand are should be framed within the context of your global asset allocation and the size of the currency premium, if any. The higher your country risk exposure, the more it makes sense to pay a reasonable premium to manage it. The lower your exposure, the more you can afford to be opportunistic.

2) Is the Rand cheap or expensive?

In December 2001, the USDZAR reached a high of 12.45, 80% above the “fair” value based on inflation differentials and long-term trends. The premium for country insurance at this point was extreme. The perceived risks did not play out, and within 3 years the exchange rate had halved. The short-term pain was compounded by the simultaneous popping of the tech bubble.

Long-term investors who bought the S&P 500 in December 2001, and held on until March 2019, would be up 321% in ZAR, or 8.7% p.a. – not great, but not as bad as one might expect for the worst timed investment of the last 20 years. Also bear in mind that things might have played out differently. We only see what did happen in hindsight making it seem like the only possibility, but the reality is that the future is uncertain.

More recently the 2016 USDZAR high of 16.87 was about 40% above our estimation of fair, still very high, but nowhere near the extremes of 2001. We estimate today’s premium at roughly 15%. For a long-term investor, this premium could easily be a lesser consideration when weighed against other factors.

The “always recovered” commentators often use 2001 as a warning against rushing for the exits when the Rand is cheap. But cheap and expensive aren’t black and white. The current exchange rate premium is much closer to fair than it is to 2001 levels.

Your context may be one of 100% exposure to South Africa, in which case you may be happy to pay the current premium to get some global exposure. A global investor’s context may be one of only 1% exposure to South Africa, in which case the premium may warrant further investment in the country.

Within the context of your exposure to South Africa, is this a reasonable premium or not?

3) Cheap relative to what?

So, the Rand is fairly cheap. But relative to what? The US Dollar? Ironically, we tease Americans about their perceived lack of awareness when it comes to the diversity of “Africa”, but many of us make the same mistake when investing “Offshore”. There is a whole world out there that isn’t pegged to the US Dollar. There’s also more to global equity markets than the S&P 500.

By our estimation Sterling, Yen, Euros, Canadian Dollars and the Swedish Krona are also cheap relative to the US Dollar. You aren’t paying much of a currency premium to invest in these places.

The relative valuations of other currencies should also be factored into your decision to invest globally.

4) Are Rand-based assets cheap or expensive? What about other countries?

One of the major benefits of a global portfolio is having access to a very broad opportunity set. This allows you to make better investments and achieve a greater degree of diversification. You might find very cheap assets in a country where the currency isn’t as cheap. Think of Hong Kong, where the currency is pegged to USD. One of our portfolio holdings is a Singaporean company, listed in Hong Kong, which does business globally. It reports and trades in HKD, but how relevant is HKD really in this equation? Should the strong HKD put us off investing here? No.

The same applies to many companies listed on major exchanges around the globe, as well as our own local exchange. Some advisors say that investors should invest locally because a) the Rand is cheap and Rand-based assets are cheap, and b) because some of our prominent local listings like BAT, Naspers and Richemont have nothing to do with the local economy. These two points are contradictory. The fact that these companies are priced in Rands on our local exchange means nothing if they earn almost nothing in Rands. These companies stand to benefit no more from a domestic recovery than Altria, Tencent and LVMH.

There are also companies listed in the US that are cheap despite the strength of the USD.

The valuation of an asset’s trading and/or reporting currency is less important than where the company does business. It is also less important than the overall valuation of the asset, where currency effects are but one factor.

In the global investment opportunity set where South Africa represents less than 1%, it is highly unlikely that our local assets are the only cheap assets in the world. Shunning the rest of the world’s investment opportunities because “the Rand is weak” makes no sense.

Most investors would agree that diversification is a good thing, but how many of us really understand what it means? All too often, South African investors think about global diversification as fleeing risk.

Diversification is about managing risk. It is not about avoiding or eliminating risk, which cannot be done without sacrificing investment goals. It also isn’t about trading one risk for another presumably lesser risk, nor should it be about taking risk indiscriminately for the sake of diversification. It is about making good investments but spreading them across different risks.

With this in mind, we address two misconceptions that many South Africans have about global diversification:

1. Moving your assets from South Africa to the UK is not global diversification

South Africa is an emerging market country with significant political and currency risks. The local stock market represents less than 1% of the global opportunity set. By now, most of us know this. This doesn’t make South Africa a bad place to invest, but it does make it a risky place to invest everything, which is what many local investors do.

For those South Africans who have decided to invest offshore, there often seems to be a significant bias towards the UK – possibly because the UK is familiar: Shared history, language overlap, similar time zones, etc. The idea is that the UK, a more developed market, has lower political and currency risk. Global diversification done.

There are two problems with this thinking. First, the UK only represents about 4% of the global opportunity set. Second, as Brexit has made it abundantly clear, the UK also has political and currency risks. The UK can still be a great place to invest, just not too much.

Have a look at two recent Business Insider headlines:

The mega rich are bailing out of Britain in the thousands, and many are moving to Australia

These incredible graphs show that the pound is starting to look like the rand

These articles demonstrate how any country, not just emerging markets, is subject to political and currency risk. Developed market risk may be lower than emerging market risk, but it is still there, and it needs to be managed.

A South Africa/UK portfolio might be better than South Africa-only, but this strategy remains vastly inferior when compared to true global diversification. The SA/UK portfolio still only represents 5% of the world, and 50% or more of your money will still be subject to the political and currency risks of just one country. Even worse, as recent events in both South Africa and the UK have demonstrated, the probability of simultaneous turmoil in any two countries remains uncomfortably high.

The answer also isn’t to move everything from the UK and concentrate it somewhere else, like Australia. This doesn’t solve the problem, it just moves it. Outside of the United States, no single country represents more than 10% of the global opportunity set, and even the Americans would do well to consider the rest of the world.

Global diversification means avoiding overconcentration to any country and taking advantage of the widest opportunity set possible: South Africa, UK, USA, Switzerland, Canada, Australia, Hong Kong, Japan, Europe, and so on.

2. The argument that “other places have their own risks” is not a valid case against diversification.

When making the case for global diversification, we’ve at times been countered that other countries have their own problems, and “fleeing” South Africa is just “swapping one devil for another”. This argument misses the point of diversification.

First, global diversification isn’t about fleeing one country for another, and in doing so exchanging one concentrated risk for another. This doesn’t manage risk, it just transfers it somewhere else.

Second, global diversification as a strategy doesn’t rely on finding places without risk. As the first point of this article suggests, no such place exists. Instead, it relies on spreading exposure between risks that are less than perfectly correlated.

To the extent that we can find two investments with similar merit that have different risks, it is better to hold both than just the one. Our risk of loss is lower because the probability of both risks playing out is lower than the probability of any single risk playing out. To the extent that we can find many good investments with different risks, it is better to hold many than just two.

Global diversification remains the best way to find many good investments with different risks.

This does not mean that indiscriminate diversification is a good strategy. Making inferior investments for the sake of diversification is a big mistake that will result in poor returns. Fortunately, having a wider opportunity set makes it easier to achieve diversification without sacrificing investment quality or returns.

In a nutshell, diversification is about exposing yourself to a wider opportunity set in order to find many good investment opportunities with uncorrelated risks. If you want to manage your risk properly, invest globally.