Smart investing

Beware the popular stocks


A common strategy regularly used by investors is judging the attractiveness of a share by where it features amongst local unit trusts. However, According to Linda Eedes, senior analyst at RE:CM, picking stocks purely on the basis that they are popular choices amongst other investors or fund managers could result in significant capital loss.

According Eedes, while it is tempting to pick shares on this basis, this strategy can result in investors purchasing stocks at inflated prices, leading to poor performance over the long-term. More often than not, it is the unpopular stocks that are currently out of favour that investors should be choosing, as these stocks tend to be undervalued and thus ultimately produce better returns.

She says that this is especially the case for high quality businesses. “If you want to invest in high quality businesses at cheap prices, you have to buy them when they are out of favour. Unfortunately, high quality businesses don’t become cheap when everything is going well.”

Eedes also argues that picking stocks because they are held by professional managers may be a misleading indicator of value because some stocks, especially those that are in the top 10 of the All Share Index, will be held by many managers throughout the market cycle irrespective of whether they are expensive or cheap. “This is because most managers do not want to deviate too far from the index they are being measured against.

“Unfortunately, many professional investors have a competing incentive – to protect their  careers. One the worst things a professional fund manager can do is to be wrong on his or her own. In contrast, portfolio managers seldom lose their jobs for being wrong with the crowd – performing in line with the market, even if the market has performed poorly.”

She says that this often leads to herding behaviour and index-hugging, where professional managers do not want to take on excessive career risk by deviating too far from the market or crowd.

“The problem with this strategy is that it is very difficult to generate exceptional returns when investors are doing the same thing as everyone else.” Eedes explains that herding may create momentum, which drives prices further up in the short term, but prices are often driven far above what the shares are actually worth. Should investors buy stocks at these expensive levels, they are not only reducing their prospective returns, but more importantly, exposing themselves to the risk of permanent capital loss. “There is no guarantee that shares bought at expensive levels, when they fall, will ever recover to those expensive levels again.”

Eedes says that RE:CM believes investors are not concerned with volatility or risk relative to an index, they are mostly concerned about absolute risk or the risk of permanent capital loss. If a stock is expensive, the investor should not hold it at all, even if it is a big component of the index.

“Take Anglo American for example. It was around 15.5% of the index prior to the market collapse in 2008. If a manager matched the index, they would consider themselves neutral in terms of 'active' risk. However, during the crisis Anglo American fell from R556 to R138 per share – a loss of 75%. Despite a 'neutral position from the professional’s perspective, the underlying investor would have lost more than 11% of their portfolio in absolute terms.”

RE:CM, after several years of holding no Anglo American shares, have recently introduced a position in this stock. “When we apply realistic long term commodity prices and profit margins to each line of the business, we derive earnings levels for the group that supports an intrinsic value well above the current share price.”

An additional example of ‘unpopular’ investments where RE:CM currently sees value in are platinum shares. “Stocks such as Amplats, Lonmin and Implats have all seen significant price declines in recent markets, making them decidedly 'unpopular'. The investment case is thus: Poor recent history and a weak short-term outlook for the European automotive market has served to drive platinum and platinum mining share prices to levels that we consider attractive from a longer term perspective.

“With smaller mines shutting down, and production volumes falling, platinum supply will fall. This, along with an eventual pick-up in demand once the European automotive industry recovers, should see the industry becoming economically viable once more. The fact that these three South African platinum miners control such a large share of global platinum production and reserves puts them in a very strong position.”

She says that the most important piece of information with regards to deciding whether to buy a share or not, is “what is this business worth?”

“If investors have no idea what the fair value of a stock is, they will then have no idea whether paying the market price for it is a bargain or a rip-off. Buying businesses when they are trading at significant discounts to fair value is the best method to generate real returns over the long term. The only way to protect against permanent capital loss is to never pay more for a stock than what it is worth.

“Unfortunately, calculating fair values is no easy task – but it is possible. What is impossible is to accurately and consistently predict what market prices are going to do, so we waste no time doing this."

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Issue 72