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.
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