Secrets of Success: Why it usually pays to buy the best
Saturday 25 September 2004
We are all paying for the excesses of the stock market bubble that reached its peak four years ago.
We are all paying for the excesses of the stock market bubble that reached its peak four years ago. Tumbling share prices, shrinking pensions, imploding life company funds (with profits to the fore) - it is not difficult to compile a list of the more obvious consequences.
There are also many things to put on the other side of the ledger - as victims usually have the loudest voices, these rarely get as much coverage. Two obvious ones are a period of lower than expected interest rates (now coming to an end, at least temporarily) and shedloads of technology at prices that would have been inconceivable a few years ago - the latter the fruit of the massive overinvestment in the vogue sector of telecoms and tech that the overvaluation of the bubble years produced.
Better still for investors is the fact that valuations of shares in general are now at more attractive levels than they were in the last crazy years of the bubble: as Warren Buffett frequently likes to point out, for anyone with an eye on the future, low share prices are a positive, not a negative, devel- opment. Whether the correction in valuations has yet gone far enough to ensure rates of return from the equity market can equal or better their long-run historical averages is another matter (and far from certain).
But have we really learnt the lessons of that crazy period when companies in the hottest sectors of the market came to be valued at prices that in retrospect look absurd? Who now remembers a company called Level 3 Communications, that had plans to invest $10bn (£5.5bn) in a new fibre optic network, had no revenues to speak of and yet enjoyed an enterprise value (debt plus equity) of more than £30bn at its peak before the crash? The sorry share price trajectories of companies such as Energis and Colt Telecom tell a similar story.
One of the reasons the bubble was bound to burst is rooted in a story that is as old as the stock market itself. This is that when sectors or industries become wildly overvalued by the market, it attracts huge investment in new capacity in those areas. After a lag, this new capacity in turn creates a mismatch in supply and demand that ensures that prices - and therefore profits - have to fall. While in isolation the projected returns on capital might appear plausible to one participating firm planning to invest, in aggregate the numbers simply can never add up. When society collectively throws as much new capital at a sector as happened with the telecoms industry in the late 1990s, the results are inevitable.
It is easy to blame naïve and credulous investors for their part in creating this and other bubbles. Yet as the financial historian Edward Chancellor points out in his introduction to Capital Account, which chronicles one fund management firm's coherent analysis of how various looming market busts developed, it is too simplistic merely to blame investors alone for what happened.
Just as culpable were those who helped to create the conditions on the other side of the ledger. Mr Chancellor cites two groups who contributed to the massive over-investment in new capacity that precipitated the bubble bursting.
In one corner were the agents who directly created the bubble: greedy corporate executives, manipulating earnings and exaggerating the prospects of their firms in order to enrich themselves through stock options; fee-hungry investment bankers who brought an endless supply of near-worthless companies to the market; craven investment analysts who produced "woefully uncritical" research during the latter stages of the bubble; and risk-averse fund managers, who continued to buy shares in overvalued companies out of a fear of being left behind and losing their mandates.
In the second group are all the gatekeepers - directors, auditors, lawyers and so on - who were in a position to restrain the more extravagant promoters of excess, but who for various reasons, including in many cases a natural desire to improve their own financial position, chose not to do so. I fear that the largely uncritical media, with honourable exceptions, must also be included in this second camp.
From the perspective of a rational long-term investor, the experience of the bubble has some lessons. One is to wise up to the game of earnings manipulation that came increasingly to dominate the markets in the later stages of the bull market, and whose after-effects are still widespread.
That this game still persists is evidenced by the extreme reaction that greets any company that reports earnings even marginally below analysts' carefully massaged earnings expectations - witness the 25 per cent fall in shares of Compass Group earlier this month.
The whole idea that the value of a company can be correctly deduced from the trend in its corporate earnings is a nonsense in both theory and practice that betrays how shallow the quality of analysis in many broking firms - and how short-term the focus of many professional investors - has become. What drives the value of a business in the long term is its ability to generate cash flow and the return that it achieves on capital invested. Yet, as the fund manager Andy Brough at Schroders told me, balance sheet analysis is often not even part of the notes that firms send out these days.
In reality, quarterly or half-year income statements are so easily manipulated that they are only pointers to the value of a company. By the same token P/E ratios are just a shorthand snapshot of a company's rating in the eyes of the market, not the primary valuation criterion, as it so often seems. The trouble is that analysing a company's competitive position and seeking to identify the competitive drivers of the industry it operates in are matters that require more work and judgement than many investors, professional and retail alike, are willing or able to attempt.
In particular the boom and bust dynamics of the capital cycle and its relationship with the stock market are complex and far-reaching, as the principals of Marathon Asset Management, the subject of Mr Chancellor's book, clearly understand. Understanding such dynamics helps to explain, among other things, why value investing by and large produces superior long returns and why investing in IPOs is on average not a rewarding activity - two lessons that those who suffer from a market crash usually have to find out for themselves each time a bubble bursts.
Independent Partners; request a free guide on NISAs from Hargreaves Lansdown
- 1 Amy Winehouse statue unveiled in Camden
- 2 Lego breaks out of the toy box and heads for the gallery
- 5 A bottle of wine a day is not bad for you and abstaining is worse than drinking, scientist claims
George Galloway on Scottish independence: The political class is doing what Hitler couldn’t – destroying Britain
Daniele Watts: Django Unchained actress detained in Los Angeles after being mistaken for a prostitute
Scottish independence: Nationalist leader Jim Sillars threatens pro-union companies with 'day of reckoning' after independence
Scottish independence: Yes campaign feels the heat as Alex Salmond's NHS claims come under furious attack
Scottish independence: Britain faces 'constitutional crisis' at next election
£23m Birmingham cycle scheme is attacked by Tory councillor for not catering to the elderly
iJobs Money & Business
£280 - £320 per day: Ashdown Group: The Ashdown Group have been engaged by a l...
£400 - £450 Per Day: Clearwater People Solutions Ltd: **URGENT CONTRACT ROLE**...
£35000 - £38000 per annum + Benefits: Ashdown Group: Training Coordinator / Pl...
Data Governance Manager (Solvency II) – Contract – Up to £450 daily rate, 6 month (may go Permanent)
£400 - £450 Per Day: Clearwater People Solutions Ltd: We are currently looking...
Day In a Page
A first-floor flat with two bedrooms, a spacious reception room and communal grounds in a leafy part of London
A three-bedroom flat with a spacious rootop terrace and balcony, accessed from a private gated courtyard
A Grade II-listed pile with six bedrooms, stables and 39 acres of grounds in Standlake
A two-bedroom flat with boutique hotel-style interiors, close to the foodie haunt of West End Lane
A two-bedroom flat in a beautiful old vicarage, with many original features, close to the city centre
A three-bedroom 16th-century home with an aga kitchen, private gardens and heated outdoor pool, in Hadleigh
A three-bedrom home in sought-after Queen's Gate Mews, with Italian marble-finished bathrooms
Surrounded by glorious countryside in the village of Udimore, sits this impressive four-kiln oast and barn conversion
A five-bedroom house in the picturesque village of Kettlewell, north Yorkshire
An 18th-century former coaching inn with original staircase, open fireplaces and beams throughout
A Grade II-listed Georgian town house with three bedrooms and a south-facing courtyard, near Arundel Castle
Feel on top of the world at this über chic penthouse on the 37th floor of one of Europe’s tallest blocks.
A Grade II-listed Victorian villa with six bedrooms and two further cottages, all with spectacular sea views
A grade II-listed, Georgian cottage with mature 50ft garden, perfect for summer entertaining
A magnificent Georgian pile with turrets, seven bedrooms, a heated pool and four acres of gardens
Fairoak Farm has five bedroom suites, gym, outdoor swimming pool and golf course
Chic two-bedroom river-fronted flat with a private lift that delivers you directly to your home
A spectacular seven-bedroom Tudor pile, once owned by Henry VIII, with 18 acres of land
A seven-bedroom Georgian property previously used as a picturesque wedding venue
A split-level flat in a church conversion with two en suite bedrooms and 1,200sq ft of living space
A three-bedroom bungalow situated behind an impressive stone wall, £645,000
Windsor Castle overlooks this three-bedroom Victorian cottage located on one of Windsor's smartest roads
Chapel House is a former vicarage with nine bedrooms in the beautiful Upper Wye Valley
A five-bedroom B&B and separate owner's accomodation with potential for conversion
Enjoy summer by the Thames in this two double-bedroom converted warehouse in Rotherhithe village
A one-bedroom, luxury apartment with private gym and concierge service in Moorgate
A four-bedroom house in Hermitage Gardens with three reception rooms and landscaped gardens
A seven-bedroom Grade II-listed property with a separate self-contained apartment
A five-bedroom Victorian house with three reception rooms and galleried landing, £695,000
A six-bedroom farmhouse with five acres of land in a former cloth-making village
A secluded seven-bedroom detached house with large private garden, £490,000
A three-bedroom cottage overlooking Sarratt village green with open fires and solid oak floors
A three-bedroom maisonette flat in a Grade I-listed, Georgian townhouse in a sought-after location
A one-bedroom apartment located within a private gated development, north of Turnham Green
Look forward to a brighter future at two-bedroom Sunny Cottages, ideal for Londoners looking to downsize
A three-bedroom red-brick cottage with outbuildings and pretty gardens, £200,000
This three-bedroom flat within a former textile factory spans the corner of the fourth floor and has a balcony