Starting an investment career in the aftermath of a market crash might be a scary experience but can ultimately teach fund managers how to avoid deceptively cheap stocks and focus on the long term, according to Troy Asset Management’s Sebastian Lyon.
In his latest investment report, the Troy founder (pictured) argued that the timing of when a fund manager starts in the industry can often have a longstanding impact on how they invest over the following decades of their career.
An investor starting their career in the early 1980s, for example, would have discovered “the rewards of optimism” as they went through one of the strongest bull markets in history. This bull run lasted 18 years before coming to an end with the bursting of the dotcom bubble in 2000.
Those joining the industry in the early 1970s, on the other hand, would have been left scarred the drawdown of almost 70 per cent that came with the 1973/4 bear market. Likewise, anyone starting after 2010 just after the financial crisis would have a much different take on things to those entering in the rising markets of the mid-1990s.
Annual performance of FTSE All Share since 2000
Source: FE Analytics
“While some are forever seeking out of the next water-into-wine stock, others have learnt the virtues of capital preservation and look to the downside before considering the upside,” the FE Alpha Manager, who runs the £4.4bn Trojan fund, said.
“I started my career in 1989, following the shock of the 1987 crash. The UK economy was heading into a double-dip recession. For three years, markets tracked sideways but with materially divergent performances for their constituent parts. High return on capital businesses such as pharmaceuticals, brewers and distillers made money while cyclical domestic businesses like banks, engineers and housebuilders were disastrous investments.”
These events taught Lyon some lessons that he has adhered to over the rest of his career, namely that some traditional valuation metrics can be “useless” in extreme market conditions such as the above.
Lyon noted that “ill-fated” sectors such as banks, engineers and housebuilders – which combine cyclicality with financial leverage – appeared “myopically cheap and tempting” when looked at through a multiple of earnings or their ultimately unsustainable dividend yields.
What mattered in the end, the manager said, was that balance sheets are the all-important factor in a recession. Contrarian optimists who piled into shaky stocks benefitted in brief periods of recovery but were hurt when market sentiment dipped; they failed to realise that seemingly “cheap” valuations aren’t everything.
“There is a view prevailing today that low valuations offer protection. This can be true in the right kind of business. In 2000, low valuations in ‘boring, old economy’ stocks offered protection and excellent medium-term investment opportunities,” Lyon said.
“Today’s low valuations tend to be in weaker businesses, vulnerable to economic cyclicality, transformative disruption and high levels of debt. They may be cheap for good reason. More often than not, low valuations tell you more about the quality of the business rather than an opportunity.”
Performance of fund vs sector and index since launch
Source: FE Analytics
All of the above means that Lyon placed capital preservation at the heart of the Trojan fund when it launched the vehicle in 2001. Since then, it has generated a top-quartile total return of 232.32 per cent; this has come with a maximum drawdown of just 9.81 per cent, which is the lowest in the sector (where the average drawdown was 34.19 per cent).
The FE Alpha Manager conceded that some great short-term returns have been made from sectors he avoids – such as housebuilders and retail banks. However, he said given the massive share price falls and “extreme volatility” those sectors have seen in the past means they are perhaps investments that should only be for “the most stubborn and contrarian investors with stomachs of steel”.
Instead of buying cyclical companies where their cheapness may be illusory, he prefers businesses whose products are constantly in demand even if their share price is not always bargain basement: “Our preference is for the low-ticket, repeat-purchase items that offer tasty investment morsels.”
The manager cited the example of US confectioner Hershey as a holding that ticks these boxes, as it has a dominant market share and high operating margins of 19 per cent. Other holdings that could fit into the low-ticket, repeat-purchase bracket include Coca-Cola, Nestlé and British American Tobacco.
Lyon’s process is grounded in looking at the fundamentals of a stock rather than following current stock market trends. Arguing that “stock market booms sow the seeds of their own destruction”, the manager highlighted the FANG stocks (Facebook, Amazon, Netflix and Google) and large caps as areas that have been pushed up regardless through indiscriminate buying by index funds but could be at risk. “Over-distributing” yield stocks could also be hit by a reversal in investor sentiment.
The manager concluded that the lessons of the past have taught him to wait for better, more genuine value to emerge in stock markets – and in the right kind of companies.
“At a recent meeting we were asked what would drive us to increase our allocation to equities. The answer is simple: valuation. It is easily forgotten that valuation drives long-term investment returns,” he said.
“Eight years into a bull market, it is perhaps not surprising that such axioms are conveniently ignored. Today, bears witness to a high degree of valuation-insensitive investment. Impatient capital has a tendency to find its way into inappropriate, low-return opportunities.
“Low liquidity has exacerbated the rises in equities and bonds. When investors are looking for the exits, a lack of liquidity will exacerbate losses and provide opportunities.”