The misguided assumptions that exist in financial markets.
Myths are widely held beliefs that are mistaken as truths. For example, for long periods of time, people believed (and acted) as if the world was flat. Below are similarly misguided assumptions that exist in the financial markets that I have come across during my investment career. I have found the reality that lies behind these to be invaluable in guiding my investment decisions.
Myth 1: There is no free lunch:
While I subscribe to the aphorism, “If something is too good to be true, it probably is”, I believe there is one free lunch in the financial markets, the impact of which is often understated. This has often been referred to as the eighth wonder of the world. You’ve guessed it – it’s compounding. Everyone can benefit from compounding. It is not a zero-sum game, and it does not require any special insight. The benefit of compounding can best be illustrated by the following example. If you can achieve a return of, for example, 12% a year from your equity portfolio, it will effectively double in value every six years. This means that for every R100 you put away at age 25, you will have R5 279 when you retire at 60. If you delay your savings until you turn 30, your R100 will only be worth a comparable R2 674. So, you see, it’s the last double that has a material impact on your pension savings, which means that you should start saving as early as possible to benefit from the impressive power of compounding.
Myth 2: Earnings drive share prices:
While this may be true in the short term, valuation ultimately trumps short-term earnings expectations. On their own, earnings do not create value for shareholders—dividends do. I have seen several companies that have consistently grown earnings but at the expense of shareholder value creation, which comes from generating cash and reinvesting the cash back into the business at returns that are above the cost of capital. Sometimes it takes years for the market to recognise that the emperor is in fact wearing no clothes (i.e. earnings are growing, but not shareholder value).
Myth 3: Active managers outperform the market:
This is a highly contentious issue—and while some managers do outperform their benchmark, they are certainly in the minority. If you look at the data over a particular year, you’ll sometimes find that active managers have done quite well. Unfortunately, as one increases the time horizon, the statistics get worse. Over any 10-year period, you’d be hard-pressed to find more than one-third of all active managers beating their benchmark index. Investing in the market is a zero-sum game—half will outperform their benchmark index, and the other half will not. After taking fees into account, roughly only half of the remaining group (i.e. roughly one quarter) actually beat their benchmark index. While there is no magic formula for beating these odds, a detailed, disciplined, and value-oriented approach to investing should swing these odds in your favour.
Myth 4: You can make money in the long run by investing in initial public offerings (IPOs):
This is one of the biggest myths of all time. If you look back to the 1998 IPO listings boom, there are very few companies that are still listed today. We conducted a study of all the new listings that took place in 2007. Of all the companies that were listed in 2007 and 2008, the average return they have delivered is negative 45% on an equal-weighted basis. In fact, only two companies are trading above their IPO price. With this track record, you would be much better off just investing in the JSE All Share Index rather than speculating on IPOs. The main reason that IPOs perform so poorly is that often the reason for listing is that the current owners of the unlisted business believe they can get more for the company by listing it than it is actually worth. Of course, there are some management teams that list for the right reasons and with good intentions, but these tend to be in the minority.
Myth 5: Volatility = risk:
As investment managers, we believe that our goal is to ensure that we achieve our client’s financial objectives by taking on the least amount of risk. In our view, the risk does not reside in share price changes, and cannot be summarised into a single number, such as the traditional measures used in portfolio management theory. The only risk that really matters is the prospect of a permanent loss of capital because portfolio management theory says nothing about the fundamentals of the companies you are investing in, their business risk, or their balance sheet risk.
Myth 6: Markets are efficient:
As an active manager, you would, of course, expect us to believe the equity market is inefficient. Most of the time, however, the market is probably efficient. If you view the market as a complex adaptive system, consisting of many participants all pulling in different directions, then on average prices will generally trade at close to fair value. It’s only when the market mechanism breaks down and the scale tips to either side that mispricing opportunities arise. Two examples of this over the past 25 years have been the IT bubble in 2001, and the commodities bubble in 2008.
Myth 7: We can accurately forecast the future:
This may seem obviously false, but many economists, analysts, and fund managers spend a large portion of their time trying to forecast the future. Many of these professionals earn large salaries and bonuses irrespective of the accuracy of the outcome of their predictions. I have seen numerous examples of analysts who calculated valuations on companies based on short-term earnings forecasts that never materialised. When the future turned out to be different, so did their forecasts and valuations. What they thought was a bargain, turned out to be a lemon.
WRITTEN BY RICCO FRIEDRICH
This article is a general information sheet and should not be used or relied on as legal or other professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your adviser for specific and detailed advice. Errors and omissions excepted (E&OE).