The team at DMX, managers of the TAMIM Australian Equity Small Cap IMA, have noticed a theme of extreme caution when it comes to investing in the markets emerging over the past few months. They take a look at a few of the reasons for this and why, while clearly worth considering, they shouldn't be freezing you and costing you through inactivity.
Small Cap Investing Filtering Out The Noise - November 2016 -
Working in fund management often provides a fascinating perspective on what is happening behind the scenes in equity markets since you may actually hear what investors are thinking. It becomes particularly interesting when you notice themes in thought patterns which provide valuable insights into the current state of equity markets since ultimately equity markets reflect group thinking on a large scale. In this article we aim to filter out the noise and learn from recent investor feedback. In our opinion this behavioural information can be used to optimise future investment returns.
An Emerging Theme: Extreme Caution
We have noticed a number of recurring comments in recent months which all add up to the same underlying theme at present: extreme investor caution.
This essentially confirms the data presented in the chart below which shows that global fund management cash levels are currently at a multi-year high and well in excess of the post-GFC spike in cash levels. This is a relatively unusual situation which highlights just how bearish the global financial community is at present. We can’t remember a time in recent years beyond the aftermath of the GFC when the consensus was so negative.
What Does It Mean?
As keen believers in the explanatory power of behavioural finance we spend a lot of time considering what investors are doing and thinking since we are aiming to buy when the market is cautious and sell when it is fearless. In this light we can draw two clear conclusions from the current state of affairs:
All other things being equal, these elevated global institutional cash levels suggest markets are now arguably sensitive to any good news, and insensitive to any bad news.
We need to understand why investors are so cautious in order to properly understand the extent of what appears to be a compelling buying opportunity. If the reasons for the extreme caution are over-stated this appears to be a clear buying opportunity but if the markets’ concerns are under- stated this is clearly not the case. We need to focus on the why.
The “I’ll wait for now” Excuse List
So let’s delve into the list of excuses we have encountered of late for investors’ caution in relation to equity investing and let’s discuss each point – we note that some of these excuses apply to global equity markets and some are more specific to Australian smaller companies investing: 1 - “The global economy is weak.”
This is undoubtedly the consensual view at present, and it is definitely being reinforced in peoples’ minds by the constant barrage of negative media articles and emails predicting the end of civilisation.
However, the recent data shows that the global economy is currently relatively stable on a low growth trajectory:
In our opinion, whether the global economy grows at 2% or 2.5% over the next year won’t significantly impact upon any of the underlying portfolio holdings. There is always the risk of a global recession but these tend to follow periods of booming economic growth which is clearly not the case at present. The very fact that global economic growth has been so pedestrian since the global financial crisis gives us a degree of confidence that we are not exiting a boom and thus entering a bust.
2 - “China is falling off a cliff.”
We are by no means experts in Chinese economic forecasting but remain cognisant of the risks posed to Australian companies by slowing Chinese growth. However, recent data has been more encouraging as shown below:
The key points to highlight from this article are that whilst 81% of the sub $100m ASX listed universe is loss-making, and 90% don’t pay dividends, 83% of the underlying portfolio is invested in companies which are growing their earnings and paying dividends, or is held in cash. We view this as a robust strategy to mitigate the risks inherent in smaller company investing.
4 - “I am concerned about more downgrades for ASX corporate earnings looking forward.”
The past 3 years have clearly been a difficult period for ASX corporate earnings as shown in the chart below compiled by Credit Suisse. However, their analysis suggests that the outlook is generally brighter after multi-year periods of downgrades as we have recently experienced:
5 - “I don’t have time to complete the investment application process.”
This is a common excuse across the industry which in our opinion generally masks an underlying cautiousness towards equities.
The application process to invest in the TAMIM Australian Equity Small Cap IMA involves 3 simple steps: i) Complete the Private Client form, ii) Certification of identity and address for individuals and/or entities; iii) Email/mail the application/ID into us.
6 - “I am happy with my cash sitting in a term deposit.”
We are not involved in the business of providing financial planning advice. However, in our experience investors who are aiming to create significant wealth over the long term generally need reasonable equity exposure. Cash sitting in a term deposit is likely to roughly hold its ground versus normalised inflation over the long term, and after tax may not even achieve that. Whilst a cash buffer provides valuable protection against market volatility, it is clearly not a wealth creation strategy.
7 - “I want a high return without taking any risk.”
If anyone knows how to do this, please let us know!
Breaking It All Down Into Action Points
Stick with stock picking - This is arguably the most important point because the vast majority if not all of the investor concerns listed here are likely to be nothing more than noise when we look back in 5 years’ time. From that future perspective many of us are likely to be thinking, why was I so worried? If you stick with bottom up stock analysis aimed at investing in high quality businesses which are significantly under-valued you are likely to be focusing on the right drivers of significant long term wealth creation.
Turn down the TV and radio – Stop listening to the media noise which can only serve to heighten your emotions when investing. In our experience too much media exposure only serves to make investors more short-term focused and less effective at focusing on the fundamentals.
Check stock prices once a month instead of hourly – Watching stock prices too often tends to make investors more short-term oriented and less aware of stock valuation fundamentals.
Develop a financial plan which is consistent with your long term goals and stick with the plan – This is self-explanatory; having the right plan in place and sticking with it is the only way most investors will reach their financial goals.
Remember that equities tend to out-perform cash over the long term and deserve a place in most portfolios:
Investor caution is currently at high levels with many investors focusing upon the “worry list” rather than the opportunities available at a stock level. In our experience, moments like this can offer significant opportunities for investors focused upon finding undiscovered smaller company gems. Whilst we don't know what the future holds, we do know that on average over long periods of time, equities tend to be a relatively high returning asset class. Dollar cost averaging is an effective method of building equity exposure without making a market call, and is reflective of why we slowly build our positions in the TAMIM Australian Equity Small Cap IMA.
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