Glen Finegan, Head of Global Emerging Market Equities, believes that in a world driven by short-term news flow, to properly understand investment risk, it is important to step back and consider the powerful and timeless forces that drive human behaviour, markets and asset prices.
The adage “Beware of Greeks bearing gifts” is normally used to refer to an act or event that masks a hidden destructive agenda or force. The phrase originates from Greek mythology, specifically the ending of the Trojan war, when the Greeks and Trojans had fought to a standstill.
The Greeks were camped outside the walls of Troy but their attempts to breach the city by force had been fruitless during a 10-year siege. In a fit of desperation, the Greeks changed tack and devised the idea of constructing a large wooden horse to pose as a peace offering to the Trojans. When this wooden horse was left at the gates of Troy, the Trojans believed the Greeks had left it as a pious act of surrender. Welcoming the gift, the Trojans opened their gates and wheeled the horse within their walls, which was a calamitous error. The belly of the ‘animal’ was filled with armed soldiers who now within the city walls would soon destroy Troy and allow the Greeks to claim victory.
The Trojans had taken the innocuous looking horse at face value. It looked harmless, so they lowered their physical and behavioural defences that had withstood the Greeks for years. When faced with overt danger they had repelled the Greeks, but when faced with what looked to be an act of surrender, their appreciation of the risks that lay ahead failed them.
The paradox of risk
Investors aiming to generate long-term capital gains from equities face a similar situation to the Trojans. Perception and reality with regards to the face value of the risks that they face are not necessarily the same. The basic premise for generating good returns is to buy an asset at a low price, and sell it at a high price. This would appear to be a relatively simple task yet it is not easy. This is because of the paradox of risk – the conditions that bring about both low and high asset prices are contradictory to the prevailing mood and investment outlook. When assets are at a low price and give the prospect of capital gains, the environment is often characterised by poor economic conditions, fear and risk aversion. Paradoxically, optimism is the breeding ground for increased investment risk. After a period of significant capital gains, and when market participants are confident in the future prospects for equity markets the risk of capital loss is often high. The stock market is the only market in the world where people will ‘run away’ from it when it is on sale and buy more from it when the goods are expensive.
This is not how we shop when buying goods and services in our daily lives, so why do investors fail to heed this paradox? There are two main reasons which both lie with the mental short cuts or heuristics that we have used to survive and adapt in a complex and uncertain world.
The first is that humans have a tendency to extrapolate present conditions into the future. The thinking goes, if it is warm and sunny today, it will be the same in the future. Investment markets though have proved to be ‘seasonal’ throughout their history with bouts of long glorious summers, and harsh cold winters in price terms. What we experience today is not necessarily the same conditions that we will face in the future.
Contextualising the perils of investing in emerging markets
We can see this dynamic of extrapolating the future in our own portfolio watch list today. The overall economic and business environment most economies are experiencing today is favourable. The global economy has responded to co-ordinated action by central banks. Historically low interest rates have given individuals and corporations the confidence to engage in new activity. Such conditions have been a boon for the likes of TSMC, the Taiwanese semiconductor manufacturer. The company is producing record levels of profits from a combination of its unique competitive position within the semiconductor industry combined with strong demand for its products. What is there not to like about such a situation as a potential holder of this company’s equity?
Strong business conditions have been accompanied by a re-rating of the stock to new all-time highs in terms of the multiple of book value at which the stock trades. In effect, a valuation at more than four times book value* shows that some investors are willing to pay a high multiple for high expected levels of profits.
*Source: Bloomberg as at 31 March 2018
Historically, investors in the market have also paid significantly lower multiples at times when economic conditions and profits have been less strong. There is a cyclical element to the requirement for semiconductors despite a long-term trend of increasing demand. It is this willingness of some market participants to pay a high multiple for future cash flow or asset value on cyclically strong profits that sows the potential seeds for the risk of capital loss.
The high multiple is a ‘Trojan Horse’. It looks innocuous, but its occurrence at a time of high profits magnifies the risks of holding the equity and the potential for future capital loss. TSMC remains on our watch list because it is a high-quality business with a strong franchise and exceptional management team. However, we do not currently hold it within our portfolios because we believe that the chance of losing money in such an equity is considerably higher than the market is allowing for.
The second factor is that humans are inherently social animals. Our predecessors were required to hunt in packs to ensure their survival and this is deeply ingrained within our collective psyche. To that end the market and business leaders often behave in a way that demonstrates that it is better to fail conventionally than to differ from the crowd.
To act upon the paradox of risk in investment terms, means at times differing from the crowd and facing the risk of failing unconventionally. The price of an asset in a marketplace is a simple function of supply and demand. When buying at a low price it is when the selling pressure is high, and when selling at a high price it is when the demand is high.
Avoid banking on the state
Bradesco, the leading Brazilian commercial and retail bank held in both the Global Emerging Market (GEM) Equities All-Cap and the GEM Equities Leaders strategy, is an organisation that has demonstrated an understanding of the contradictory nature of investment risk. During the period between 2010 and 2013, Brazil’s administration, led in part by President Lula, was encouraging the sizeable state banks to lend money to individuals and businesses to stimulate the economy. This is a situation that often occurs in countries where governments have some form of hold over the banking industry. The aim is often to create an economic environment that is conducive to their chances of re-election.
Bradesco, which is controlled by a foundation, is a patient allocator of capital, and is willing to go against the crowd or in this case the state banks. During the period of state bank largesse it recognised that this flood of capital entering the economy was charging too low a price (interest rate) for the inherent risk that defaults would occur sometime in the future. During a three-year period from 2011 Bradesco reduced the amount of capital that it lent to the Brazilian economy relative to state-controlled banks such as Banco do Brasil. This meant that when the season changed, and the worst recession since the 1930s hit Brazil in 2014 and 2015, the bank was in a strong position to ride out the storm. At the same time, the state banks had to divert capital to cover significant losses in their loan portfolios. Bradesco’s management showed that they had the patience, character and behavioural intelligence to recognise that the worst loans are made at the best of times, and the best loans are made at the worst of times, and to act accordingly.
Investment Risk ≠ Volatility
In line with our absolute return mindset we define investment risk as the risk of permanently losing capital rather than relative performance versus a benchmark index. The majority of investment industry literature and communication of risk revolves around considering risk as the volatility associated with the returns of an investment relative to a benchmark. It utilises the ‘Greeks’ to numerically convey this volatility, such as Alpha (the relative outperformance versus a benchmark after adjusting for the level of risk taken) and beta (the correlation in movement of an asset to a benchmark). This may allow a comparison of portfolio managers and their respective funds in a quantitative measure, but in many ways it can lead to sub-optimal returns. When seen within the context of the paradox of risk, volatility or sharp changes in the price of an asset are not necessarily a bad thing. Volatility creates conditions to buy assets at a lower price and potentially sell them at a higher price. It is something that investors should harness and not fear. It does, however, require a long-term time horizon because one has to have the ability to look through and wait for the changes in any given environment.
Investing alongside superior capital allocators
Understanding risk and taking advantage of volatility through the allocation of capital is a key requisite for any successful business leader. Over a long period of time, chief executive officers and business leaders have to do two things well. They need to manage the business to maximise the sustainability of their competitive advantage and profit pool, and they must deploy the capital produced by these profits to ensure continued business success. When operating within emerging markets the rewards and perils for success or failure in allocating capital are often magnified.
In developing countries the prospects for long-term economic growth driven by a demographic dividend are more often than not accompanied by immature political, judicial and financial conditions. This creates an attractive long-term opportunity for business growth, but a path that is unlikely to be smooth because of the instability found within the broader business environment. It is why we prefer to spend more of our time gaining comfort with the quality of management and franchises by developing an understanding of corporate histories and assessing their capital allocation skills.
Duratex S.A. is a Brazilian company held within the GEM Equities All-Cap strategy that is emblematic of the value that can be created for minority shareholders when time horizon, an intuitive understanding of the paradox of risk and a willingness to be contrarian are displayed in capital allocation decisions. The company engages in the manufacture and sale of reconstituted wood panels and laminated floors through its wood products division, and bathroom fixtures and fittings through its Deca arm. The end markets for both divisions are the furniture and civil construction sectors and these are inherently cyclical. Much of the demand is driven by both business, as well as banking and consumer confidence which can rise and fall through multi-year cycles. Duratex is advantaged, however, by the presence of two controlling shareholder groups (Itaúsa and the Ligna that are owned by the Setubal, Villela and Seibel families respectively). They have focussed on maintaining a conservative balance sheet so that the business can ride out any economically-induced storms.
This balance sheet conservatism allowed Duratex to take advantage of the weakness that the Brazilian economy showed in 2014 and 2015. Business conditions were tough for Duratex when Brazil experienced its worst recession since the 1930s Great Depression. Importantly, the management team continued to invest during this time, allocating R$576m in total, with R$116m to the acquisition of Ducha Corona and R$178m to the planting and maintenance of forests*. Such actions helped lay the path for continued business success. Through the Ducha Corona acquisition Duratex was able to double its market share in the electric shower and tap segment of the sanitary market at an attractive price. By consolidating the industry it also helped create a better pricing environment, which should help sustain profits into the future.
*Source: Duratex Factsheet Q415.
The world has changed significantly since the time that the Greek mythic tale of The Trojan Horse was written. We live in a world where we are bombarded with data and news that are all designed to feed us with more information. This is intended to create knowledge and ultimately better outcomes. It is important, however, to step back and understand that simple and effective investment insight can be created by considering the powerful and timeless forces that drive human behaviour, markets and asset prices.
We believe that through a focus on considering ‘the Greeks’ as a proxy for risk, a significant proportion of investment industry analysis and focus is too short term. It prioritises trying to understand and quantify the reason for the volatility and its impact on short-term returns, rather than characterising the overall attractiveness of an asset price or asset class as one looks to the future. The true risk is that a number, a quantitative measure or even a wooden horse may not turn out to be what it initially seemed. The Trojans may have not learned this lesson, but it does not mean that we need suffer their fate.
These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. Any securities, funds, sectors and indices mentioned within this article do not constitute or form part of any offer or solicitation to buy or sell them.