Rationality and patience
As you might know, I’m the co-founder of a non-public investment fund. I wrote a newsletter to our partners and I want to share the introduction with you.
Dear Partner,
Let us start with the best wishes for the new year. Good health for you and your loved ones, business successes, and many stock market gains.
At the beginning of the new year, we like to take a moment to look back to where we started last year. The title of the newsletter back then was: '2023 will be a good year.' Regardless of what happened, 2023 would be a good year. Either the stock market would rise, or we would have opportunities to further strengthen our portfolio with attractive bargains.
Contrary to expectations, it has become a bit of both. After an initial strong start, stocks dipped again, only to rise somewhat in the summer and then continue to decline, reaching a low point at the end of October, after which a year-end rally began.
Are Joël and I satisfied with 2023? Yes and no. Yes because we made some excellent purchases and increased positions in existing stocks at attractive prices. And no because the losses of 2022 have not yet been fully recovered with the rise in the stock markets.
Beating the Belgian stock market was once again not difficult, but compared to America or a global index, we are not performing as well. We also find it dreadful to have to explain why that is, because it feels like making excuses, a hindsight story to tell. And what does it matter, the results are what they are. But we still do it because it is also the explanation for why we have such strong faith in the future of our fund and the companies in our portfolio.
If you look at portfolios with very good results, you will invariably find companies from the so-called Magnificent 7. To illustrate the dominance of these stocks, here are some figures.
Magnificent 7 are the stock market
The Magnificent 7 have a market capitalization that is four times larger than that of the companies in the Russell 2000, the small-cap index consisting of 2,000 companies, starting from $250 million, so not very small companies either.
The market capitalization of Microsoft alone is as large as that of the entire Canadian stock market. Together, these seven companies are as large as all the stocks on the stock exchanges of the United Kingdom, Japan, and Canada combined. These are truly not small markets, where world players like Toyota, Sony, Unilever, Shell, Rio Tinto, and GlaxoSmithKline among others also list their stocks.
The combined profit of the Magnificent 7 over the past twelve reported months amounted to $320.3 billion. When I look at the 10 largest companies in the United Kingdom, Japan, and Canada, I come up with a combined profit of $285.3 billion for these 30 companies. In other words, only a difference of 11%. Considering that there are 1,900 companies listed in London, 1,500 in Canada, and 3,900 in Japan, there's little more to add to that.
That these seven companies are very fine, we agree with that as well. However, the price at which they are listed is a different story. In fact, these seven have become "the market." If we were to remove these seven companies from the S&P500, the performance would not be noteworthy; these seven have been responsible for the outperformance.
For those interested, I have prepared a table with market capitalization, net profit, EV/EBITDA, price-earnings ratio, composite profit growth over the past 5 years, and the growth needed in the next 10 years to justify the stock price.
Without wanting to criticize these stocks - I repeat, they are good to great companies - the prices simply don't make sense anymore. When you see that 4 out of the 7 companies couldn't achieve the growth needed in the past 5 years to justify their prices for the next 10 years, you certainly should raise questions.
The growth these companies have shown in the past five, ten, or even twenty years is phenomenal. Companies that can sustain that level of growth for such a long time are very exceptional. But you know what's even more exceptional? Companies that can maintain the same growth after such a growth period for another decade. And even if they can achieve that growth, your investment results are still going to be modest; they need to do better to deliver outperformance once again. In short, the odds are not in favor of investors in these companies.
In the past, we've experienced periods where a particular segment dominated the markets, such as oil companies and the Nifty-Fifty in the 1960s and 1970s. Be mindful, that those were also very good and even great companies, and many of those companies remain top-notch, like Coca-Cola, PepsiCo, McDonald's, Gillette, and so on. But even then, valuations were driven so high that eventually a crash followed, and investors in these companies needed 12 years or longer to recover their losses in stock prices. I wonder how many of those investors held onto these stocks throughout that entire period.
We saw something similar happen during the Dot-com bubble. Investors in Microsoft also had to wait more than 16 years before they saw a new, higher stock price than in 1999, regardless of how strongly Microsoft performed.
Or what about the Japanese Nikkei index? It is still 11% below its peak in 1990. Market mania can be extraordinary.
Although we always say that we do not want to make predictions, I will now be arrogant enough to make one. I believe that we are on the eve of such a period for the Magnificent 7. What is expensive can become even more expensive, and I cannot put a timing on it, but this will not last forever.
Active vs. Passive
The exceptionally strong performance of these seven companies has resulted in the U.S. S&P500 index also building an excellent track record over the past 10-15 years. This has significant appeal to investors who want to passively track this index through inexpensive ETFs. ETFs that track global stocks, such as IWDA, also benefit from this.
This leads to a kind of chicken-and-egg story. Because the Magnificent 7 have a weight of 28% in the S&P500 and 18.6% in the IWDA, it means that for every 100 dollars invested in the S&P500, 28 dollars go to these 7 companies, and the remaining 72 go to the other 493 companies, further distributed by size. In the case of IWDA, for every 100 dollars, 18.6 go to the Magnificent 7, and the remaining 81.4 dollars are distributed across 1,600 stocks. In other words, the popularity of investing in ETFs only reinforces this trend, driving up prices and making these indexes more attractive, thus attracting even more capital.
On the other hand, we, with our actively managed fund specialize in smaller companies, at least, small by market standards. I stumbled upon the following image in colleague Robert Leitz's quarterly report.
In this image, we see that index investing now accounts for 39% of all investments worldwide.
In the image above, we see that the money flowing into passive ETFs comes directly from actively managed funds.
In the United States, it's even more pronounced, where according to Bank of America, 53% of assets are passively invested.
The capital flow into actively managed small-cap strategies has completely dried up. Experienced investors know that stock prices decline when there is little demand, especially when there is a lot of selling. Especially in less liquid stocks like small-caps, this can lead to significant declines if there is an imbalance between buyers and sellers.
Let it be clear, we are not against ETFs. On the contrary, for many, this is a better way of investing than selecting individual stocks themselves, especially if you have limited knowledge or time. However, what you should not expect is that the results of the past 10 to 15 years will seamlessly continue into the next 10 or 15 years. This was an exceptional period with low-interest rates and other developments that fueled these indexes.
As Joël and I have already indicated, this also presents opportunities when this money flow reverses. That's why we're also asking ourselves this question: Is there any reason to believe that this flow won't reverse anymore?
Will small caps ever outperform again?
In an interview with Han Dieperink for Investment Officer, we read the strongest arguments against such a revival of small caps in general.
In the past, small caps achieved a higher return than larger companies, partly due to a premium on what was considered higher risk, along with the illiquidity of the stocks. This, combined with an information gap where active managers could make a difference. However, this information gap has disappeared; with the internet, all information is instantly available to everyone.
The same internet and online brokers should also improve the liquidity of these stocks. After a period of improvement, we saw that it deteriorated again, especially in recent years. In addition to capital flowing into ETFs, as discussed earlier, stricter regulations have also contributed to fewer brokerage houses following these smaller stocks.
Due to decreasing liquidity and attention for these small companies, it is also becoming increasingly difficult for them to raise money on the market when they need it for growth. Many companies are therefore questioning the added value of a stock market listing, especially considering the rising costs of listings. Not only for the listing itself but also because of all reporting obligations, including recently added ESG reporting.
The prestige of a stock market listing is also not what it used to be. Nowadays, a well-known private equity partner is often considered just as good or even better, because they are not dependent on market fluctuations when raising money.
Private equity, therefore, serves a need for companies, allowing them not to go public anymore. Private equity gets the best opportunities, which worsens the ratio of listed small caps compared to before. In the United States, the number of listed companies has decreased by 45% since the peak in 1997, with small caps experiencing a 60% decline. A similar trend can be seen in Europe.
If companies can grow faster with private equity partners than through the stock market, where the market imposes many additional obligations, it has a negative impact on listed small caps as a class as a whole. This means that only companies unable to secure financing from private equity or when private equity partners and founders want to benefit by selling their shares at inflated prices will go public. The remaining small caps may be larger companies that are no longer considered large for some reason, in other words, the less valuable. Companies undergoing a revival may be taken off the stock market by their owners or private equity before their market value has fully recovered.
Separating the wheat from the chaff is exactly what Joël and I are doing, but with a poor reputation for small caps as a whole, it will take longer for our good companies to attract market attention, and there is a greater risk that they will be taken off the stock market at too low prices.
The above argument supports investing in holdings to complement our portfolio. All of our holdings are also active in the private equity market.
Regardless of the reason, whether it's the flow of money into passive funds or private equity making small caps less attractive, the result is clear. In the United States, despite the rise in the fourth quarter, small caps are still close to their lowest valuation in the past 20 years. I couldn't immediately find data for Europe as a whole.
However, if we purely look at the numbers, we see that the S&P500 has a valuation of 23.2 times the price/earnings ratio, while the stocks in our portfolio (excluding cash and holdings) are trading at 10.8 times, with the expected growth not being significantly different. Which of the two would you want to own?
Reversion to the mean
One of the most powerful forces in the stock market is what they call 'Reversion to the Mean,' or the return to the average. It is a financial principle that states that the prices and returns of stocks will eventually return to their long-term average multiple or average growth rate. This means that the performance of a stock or a stock market index that is extremely good or bad in a certain period is likely to return to a more normal, average level.
For example, if the stock market experiences a period of very high returns, 'reversion to the mean' suggests that returns will eventually decrease to a more sustainable level. Conversely, if the market goes through a period of poor performance, this principle may indicate that improvement is likely on the way.
Specifically, in our case, this would mean that the prices of our stocks would rise, while the excessive valuations of the indexes, especially the S&P500 and IWDA, and particularly the Magnificent 7, would decline.
If you believe in this principle, which has been confirmed time and time again in the world of finance, it offers opportunities for rational and patient investors, which we consider ourselves to be.
On the subject of interest rates, we also see that this principle has held true. After an exceptionally long period of continuously declining interest rates (since the mid-1980s) and an equally exceptional period of near-zero interest rates, we are now witnessing an increase in interest rates. Although these interest rates may seem high to many, historically, they are still at the lower end of the average.
These higher interest rates should also have a positive effect on the relative valuation of our companies, which have a low level of debt compared to other publicly traded companies. However, we have not yet seen this reflected in stock prices.
Or in the words of Howard Marks, who emphasizes the cyclical nature of the market, the cyclical movements that lead to this 'Reversion to the Mean':
While there’s no fixed point that represents the official start or end of a cycle, most economic cycles can be described as follows. Notably, each step in the cycle causes the next.
First, stimulative rate cuts bring on easy money and positive market developments;
which reduce prospective returns;
which leads to willingness to bear increased risk;
which results in unwise decisions and, eventually, investment losses;
which bring on a period of fear, stringency, tight money, and economic contraction;
which leads to stimulative rate cuts, easy money, and positive market developments.
And also, the following quote from the well-known investor John Templeton applies to Chess Capital:
If you buy the same securities everyone else is buying, you will have the same results as everyone else.
Of course, we must acknowledge that this strategy did not yield the desired results last year
And the future?
In the media, you've probably read many future predictions or expectations for 2024. This year, Joël and I have even less of an idea of where things will go. Fortunately, for our investment approach, it's not relevant at all.
What we plan to do is exactly the same as what we've been doing in recent years. This time, we rely on the principles of top investor François Rochon to explain this. We will continue to be humble, rational, and patient.
Humble: We realize that we cannot predict the macroeconomy. Examples like the wars in Ukraine and Israel, the COVID-19 pandemic, and attacks on ships in the Red Sea underscore this. We stay within our field of expertise and aim to continually improve ourselves. We acknowledge our mistakes, primarily to learn from them.
Rationality: We don't get caught up in fads. We don't care about what the next popular toy in the stock market is, and we don't try to time it. Our focus is on what really matters, which is the financial results of companies and their future prospects.
If we don't understand something well enough or can't assess it, we simply stay away from it. We realize that we can't predict the future, so we focus on our process. We are also willing to accept weaker years. Although 2023 wasn't bad, it simply didn't match the results of 2022.
We understand that this is part of investing. Investment styles come and go, and when our approach is not popular, others may perform better.
Patience: Our patience is currently being put to the test. The only way to deal with this is by maintaining our focus on our companies. That's why we invite you to ask us questions about our companies.
It's important to note that patience is not the same as stubbornness. We continue to closely monitor our companies and are constantly looking for reasons why we should no longer hold a particular company. We must avoid, as the proverb says, being like a frog placed in boiling water. We must not get stuck in companies whose fundamental performance is deteriorating but that we don't want to sell out of fear of loss.
Excellent read, thank you and good luck for 2024 and beyond.