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Value investing in 2018: Defence will be as important as the offence

Globally, we are now almost ten years into a period of extremely lax monetary policy which has achieved modest economic growth, skyrocketing asset prices with little or, in some cases, no deleveraging of debt burdens.

Central bank action has also underpinned public fiscal deficits and kept alive failing (‘zombie’) private companies. In short, it has delayed the necessary restructuring away from the debt-driven patterns of consumption which played a key role in causing the Financial Crisis.

Politically, this process has been buttressed (in Western democracies, at least) by the inability of voters to reward politicians for telling the truth about economic growth, taxation and inequality.

For several years now, investment returns across a whole swathe of assets have significantly exceeded underlying measures of economic or financial performance. In these low-low years (low volatility and low cost of capital) investors have become increasingly complacent about the levels of risk they are prepared to assume. Yields on low quality assets such as junk bonds have collapsed. For the first time since the financial crisis we are seeing the rise of new esoteric instruments. Recently seasoned investment bankers have spoken out on the merits of the Bitcoin. Something they failed to mention when the Bitcoin price was far below current levels.
None of us know how long the current cycle (in both economic and market) terms will continue. Much attention has been paid to predicting the pace of monetary policy tightening in the major economies. In truth it is the longer-term level of interest rates that plays a more important part in determining company valuations, given its role in discounting future corporate cash flows back to an estimated present value. Also given the relative lack of alternatives to equities, investors should not simply shift capital out of the market in an attempt to ‘time the market’.
However, as we head into 2018, investors would be wise to adopt an even more prudent attitude than normal. In particular the following situations should be approached with extreme care, if not avoided altogether:

• Speculative concept companies
• Highly geared companies
• Companies overly reliant on the economic cycle/operational leverage
• Companies now engaging in aggressive M&A having eschewed attractive investment opportunities earlier in the cycle
• IPOs – these are now coming on higher multiples and debt levels than before

These categories are not mutually exclusive. The worst candidates for investment frequently offer a combination of such factors combined with the usual short-term positive ‘mood music’. The latter ranges from things like temporary earnings upgrades, driven by one-off or other short-term factors, through to a widely noted ‘positive tone’ from a results meeting with management.

Instead high levels of care and attention should be fostered on all existing and prospective investments. In particular investors should focus on companies with the following attributes:

• Understandable business models
• A high and sustainable return on invested capital
• Exposed to long-term growth drivers rather than short-term cycles
• Supported by self-help/management actions
• Strong balance sheets
• Attractive valuations – pay attention to free cash flow yield

Each individual investment will, of course, be different and it is hard to be too prescriptive, but I strongly believe that a well-diversified portfolio of stocks flavoured with the characteristics noted above will perform relatively well over the next few years.
Above all investors should not be afraid of investing in companies that other investors consider boring or staid. 2018 may well see a renewed battle for investment survival after the phoney war environment of the recent past. If so, then, defence will be as important as offence. Value investors must remember to stay safe and not panic.

This article was first published by Investment Week on 20 December


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