The fundamentals of investing
For intermediaries only
Introduction from Nick Dixon, Aegon Investment Director
Working with Morningstar over the past few years as Aegon’s investment adviser, I have observed something. They are not an excitable bunch. I doubt any of them got an ‘easily distracted’ on their primary school reports.
This is a helpful attribute if you’re a long-term investor. It’s very easy to let emotion drive behaviour – both fear of losing money or over-confidence. This month, I let Morningstar explain ‘fundamentals’ and what this means for the portfolios they advise on, including Aegon’s Core and Select Portfolios.
Over to Morningstar…
How stock fundamentals affect the share price
If we have learned anything from financial market history, it is that the fundamentals of the market matter. This is depicted in the chart below, which demonstrates the gravitational forces of fundamental pricing relative to market pricing.
Source: Morningstar Investment Management calculation, S&P 500 (US market) returns normalised at 1 in 1871 on a log scale. Shiller data as at 31 March 2017. The above is an illustration only and not intended as an inducement to buy or sell any particular investment. Past performance is no guide to future performance. The value of investments can go down as well as up and investors may get back less than invested.
Fundamentals can be considered an independent measure that acts as our hurdle or gravitational baseline. Prices will move around it, sometimes diverging for decades at a time, but we know it gets incrementally harder for market prices to push further and further away from the fundamental drivers of the market.
The trick as asset allocators is to avoid markets which have significantly outstripped the baseline, because the risk of a gravitational drawdown increases commensurately with the distance it diverges from that line. It is akin to borrowing returns from the future that will need to be repaid.
Price risk is therefore much higher than fundamental risk in this scenario and history has demonstrated that the market has a much higher likelihood of suffering a drawdown in price than fundamentals.
In our world, the fundamental baseline is calculated using the cash flow generated from the investment. For equities, that encompasses an assessment of dividends (including buybacks) and the expected growth in those dividends over time. While the logic that underlies fundamentally-driven investing is undoubtedly strong, there are at least two core challenges to its successful implementation.
The first of these is to have an independent mindset. It is easy enough to see compelling evidence and comprehend its usefulness, but it is much harder to turn this into an actionable outcome. Bringing this into context, we know that it is important to monitor how far prices diverge from the fundamental baseline, but it can be extremely challenging to hone one’s focus without being subjected to behavioural biases and short-term thinking. We know that divergences from fair value can last a long time and investors require patience as a prerequisite to success.
The second is that we should understand risks to the fundamental baseline. While it would be wrong to implicitly expect fundamentals to increase in a straight line; historical precedence shows that drawdowns in ‘fundamentals’ can occur if pay-outs are cut, it is also dangerous to make predictions. The idea is to identify any risks that would shift the intrinsic value of an asset and build this into the assessment with a sufficient margin of safety.
What does that mean today?
Finding a margin of safety in today’s world is becoming increasingly challenging. While the fundamental baseline is seemingly healthy for many markets, with payouts and growth making reasonable progress, we find that market prices continue to be ‘priced for perfection’. This difference between price and intrinsic value is what concerns us the most in the current environment and we must, therefore, become increasingly cautious about the gravitational drawdown this might entail.
Source: Morningstar Investment Management calculation at 1 July 2017. The above is a projection and an illustration only. It’s not intended to form an inducement to buy or sell a particular investment. Past performance is no guide to future performance. The value of investments can go down as well as up and investors may get back less than invested.
That is not to say that there aren’t any opportunities available for investment. Our contrarian framework allows us to see value amid chaos, and we have been taking advantage of these perceived mispricing opportunities. It is worth noting the diversity within emerging markets and how that can impact vehicle selection. Emerging markets, especially in Europe, have been a favoured area of capital allocation for us in recent times as sentiment turned sour in mid-2016 and a margin of safety developed. We are also seeing windows of opportunity at a sector and sub-sector level, with energy and more recently telecommunications coming onto our radar.
To the contrary, we are also seeing dangers. Central to this is the broad US market, where prices have been outstripping the fundamental baseline by a significant margin. With dividend yields deteriorating, the only way the US can sustain its fundamental baseline is for payout growth to increase at a faster rate. Problematically, the US market now accounts for more than half of the global index, and we fear that any unwinding of the optimism held in this region could easily create pain for passive global holdings.