The trend is not our friend

CIO Insights 1Q2023

It is probably fair to propose that the overwhelming share of liquidity looking for a home in the financial markets tends to follow a “path of least resistance.” In the equities markets, this means that investable cash usually seeks out the most populated, easily tradable and seemingly “safe” countries and sectors in companies whose stock chart displays an established uptrend. Oftentimes, and especially so in times of market stress, this is done without any regard to price paid and value received. We believe that there are many causes for this, chiefly attributable to socioeconomic and structural factors.

In behavioral terms, human beings are attuned to recognizing and joining trends in order not to be left out. Both necessity and convenience drive us to belong to a broader community in search of comfort, support, protection and opportunity. Less philosophically, in our view there are three main technical forces at work that lead financial decision makers onto the path of least resistance. The first relates to the design of economic models. In trying to predict the future trajectory of time series, extrapolation tends to be the norm and other patterns—mean reversion, for example—the exception. Undoubtedly, spotting a trend and arguing for its continuation is considerably easier to pull off than hypothesizing a disruption thereof. The second force relates to modern market dynamics. Passive investment programs and products nowadays constitute the biggest share of incremental money flows. Most of these instruments are mechanically designed to invest in companies with the largest market capitalizations, which in turn is a direct result of strong previous stock price appreciation. And third, the stock brokerage industry is heavily geared towards recommending stocks whose prices have had a successful run over the recent past.

To sum up the discussion above, when it comes to placing money in publicly traded equity securities, it is commonly considered “safe” to adhere to consensus and “risky” to deviate from it. The problem with this behavior is that the rational economic evaluation of the relationship between price to value gets lost in the process. Needless to say, the safety trade can sometimes turn out to be quite expensive. To borrow a recent example from the fixed-income markets, long-dated sovereign bonds of prime “hard-currency” issuers are generally considered safe. However, starting around two years ago they have turned out to be a very costly portfolio holding after it had become evident that interest rates would perk up as a result of rising inflation.

On the flipside, risk may be attractively priced if it is overestimated by the prevailing consensus. It is both our conviction and professional duty vis-à-vis our clients to follow this approach. We make it our business to proactively and constructively think about risk and embrace it as a potential opportunity in case we believe it has resulted in an excessive share price discount. To see the implications in terms of current investment positioning, the conventional view has concentrated their bets in “safe” but perhaps expensive themes such as high-tech, healthcare and consumer staples. By contrast we prefer arguably “risky” but potentially inexpensive sectors that are not prominently represented in the major equity indices. These include capital goods, industrials and materials, as well as asset-heavy services such as transportation, utilities, telecoms and commercial banking. Our careful evaluation and conservative valuation of select companies in these areas suggest that their share prices may be unduly depressed because of their reputation as recession sensitive and resource intensive “lower quality” assets.

To recall, the most fundamental concept in deep value investing is the margin of safety—the difference between the price we are willing to pay for the value we expect to get. It constitutes the reference point that helps prevent us from stepping into the “safe-but-expensive” trap. Consequently, we don’t subscribe to the well-known market wisdom that “the trend is your friend.” While we may not be with the “in”-crowd, we are convinced that our particular style of deep value investing is a timeless handicraft worth pursuing. Our clients certainly appreciate and even count on the complementary and diversifying effect they obtain from our approach when viewed in the context of their overall investment programs.

Sincerely,