Lessons from managing other people’s money

The 21st Century is all about instant gratification and quick reward. Consumers want bullet-proof product and services delivered to them the day before they order them, and at half the price; investors want their 10-year returns deposited in their bank accounts with zero risk, and within six months of opening their investment accounts; and new hires want to be promoted to the C-suite or executive level immediately following their interview.

It takes time in the market, fool

Among all this craziness it is refreshing to sit back in an auditorium seat and listen to an ‘old school’ investment expert, an asset manager who understands that it takes time in the market to deliver investment returns and exudes the knowledge and skill that goes with a three-decade-or-longer stint in the financial markets, managing other people’s money. This opening describes the setting when Chris Freund, a Portfolio Manager at Ninety One, took to the stage at the asset manager’s recent ‘A perfect storm’ webinar. He described his presentation as ‘reflections on a long career of managing other people’s pension funds in the mostly institutional market space’. 

Freund’s take on the three overarching types of bear markets was intriguing, and this writer must confess to not having heard as succinct an explanation before. Type one is labelled sudden shock involving an unforecastable catastrophic event or political catalyst: think 9-11 or Covid-19. In this scenario, financial markets will fall rapidly, losing 25-30% of value almost overnight. “My only comment on this type of bear market is not to worry about them, because markets tend to recover very quickly from such shocks … there is no underlying economic imbalance that needs to be fixed,” said Freund. The sharp V-shaped recovery in global financial markets in March and April 2020 illustrates this point. 

Is this the longest duration bear market?

The second type of bear markets is a financial recession which turns out to be more problematic. “These occur when the banking system goes a bit mad and too much credit is extended … credit bubbles form … and the money finds its way into property markets,” said Freund, siting the 2008-9 Global Financial Crisis (GFC) as a truly globalised version of this recession type. He observed that the Asian financial market crisis in the late 1990s had been a kind of doubling down on the ‘sins’ that trigger financial recession induced bear markets, because investors not only borrowed too much money to pump into an overheated property money but did so in hard currency. It takes years for financial recessions to unwind because overextended banking sectors need fixing / recapitalisation. 

The third type of bear market, branded the garden variety or vanilla recession, is playing out in global financial markets as this writer taps at his keyboard. “We are talking here about slower economic activity resulting from overheating economies and concerns about central banks putting up interest rates too much,” Freund said. To summarise: March to April 2020 was a sudden shock; 2008-9 was a financial recession; and 2022 is looking like something the world has not seen since the early 2000s, when the dotcom bubble burst. 

Four phases in the economic / financial market cycle

Freund spent some time explaining economic and financial market cycles through four distinct phases, before he concluded that we were probably in the fourth phase: “We are in the overheating and decline phase of the economy, and that corresponds to the despair phase of the equity market”. More specifically, the economy is at an inflection point that will most likely roll over into a full-blow recession. Ironically, this recession is often exacerbated by over-enthusiastic central bank action. 

One of the major concerns during times of high inflation is that central banks will push interest rates too high, because the impact of their monetary policy interventions take time to reflect on inflation measurements. “Sometimes central banks continue putting up interest rates even though economic growth has started to slow down because that outcome is not reflected in the inflation number,” said Freund, who used the “this time it is different” disclaimer to describe the macroeconomic underpin that preceded this part of the interest rate hiking cycle. The unusual fiscal and monetary policy approach taken by developed markets in multiple years following the GFC, which continued through the 2019-20 pandemic, have contributed to record levels of liquidity combined with near zero interest rates. 

“The market actually started to believe that interest rates were never going to go up again, and we had what can best be described as a period of euphoria on global equity markets,” said Freund. He referred to the surge in initial public offerings (IPOs); merger and acquisition activity; and special purpose acquisition companies (SPACs) in the United States over the period 2020-21 as evidence of market craziness. As it turns out, US equities ran hard deep into the last quarter of 2021, but since then things have come terribly unglued. The tech-heavy Nasdaq peaked in November 2021 at an all-time high above 16000 points, before stumbling 35% by end-September 2022. 

Depth and duration of recession uncertain

According to Freund, markets are now responding to investors’ expectations of an economic recession, with the depth and duration of this recession dependant on when central banks stop hiking rates. “My view is that inflation is going to roll over, if it has not rolled over already, [meaning that] central banks will soon hint at coming to the end of their interest rate hiking cycles,” he said. This realisation may result in a short-term equity market rally that will soon fizzle out as investors cotton on to the reality of the economic slowdown, which will likely persist for a number of quarters. Asset managers watch a variety of economic measures for an indication of an improving economic outlook, Freund’s favourite being the US jobless numbers. 

As for when to pour money back into global equities, Freund remains uncertain. “It is too early for me to get excited for equity prospects, and too late for me to position very bearishly,” he said. However, he was quite confident that the hopeful phase of the market cycle would kick-off before December 2023, with the next economic upturn taking place into 2024. Having a view on the economic and market cycle is just one part of an asset manager’s job. The tricky part is determining the correct asset allocation within each fund to provide optimal returns, within fund mandate and through the cycle. 

Some pointers on investment styles

It is impossible to share all of Freund’s insights in this 1000-odd word newsletter. However, we can share some pointers that might make it easier to guide your clients through these difficult times, and certainly give them peace of mind that the asset managers you partner with have the capability to deliver returns through the cycle. First and foremost, the portfolio manager commented that there was more to life than the value investing methodology. “The value philosophy is the first one that most people get taught … but the value discussion ends up going the ‘beauty is in the eye of the beholder’ route [with the added risk] we become too dogmatic about how much something is worth,” said Freund. 

This writer loved his no-nonsense dismissal of trying to put a price-tag on a share: “Do me a favour,” he exclaimed, “if you come up with a ZAR100,00 valuating, then the best you can conclude is that the asset is worth somewhere between ZAR80,00 and ZAR120,00 because there is too much subjectivity in the variables”. Further contraindications for investing using the value methodology included that “cheap shares stay cheap unless there is a catalyst” and that “shares with the lowest value rating are there for a good reason”. In this context, stock pickers are better off using valuation as a risk rather than a return metric. 

The growth philosophy came in for criticism too because its central premise is buying shares that have a very high historic and / or forecast earnings expectations. “This is a losing investment philosophy, and I can point you towards a plethora of academic research which says just buying a portfolio of shares that have very high forecast earnings growth will underperform the market,” said Freund. He added that this philosophy has its moments when everyone believes an economic boom cycle will last forever… After a few rather noncommittal words on the quality investment philosophy, Freund introduced the strategy that has served him well over decades. 

The Holy Grail of investing

“What you must try and do, in my opinion, is buy shares that are at most mildly overvalued, but exhibit upwards earnings revisions … meaning that the expected future profits are baked into the consensus view,” he said. This philosophy considers that today’s share prices reflect the market expectation for future profit: if those profits are forecast to be high, then today’s price is likely expensive and vice versa. “On a through-the-cycle basis, this particular style of managing money ensures less heart failure for your clients, and you do not have to wait five years to be a winner,” concluded Freund. 

Writer’s thoughts:
Soaring inflation and the resulting central bank interest rate hikes have put a damper on the returns generated by various asset classes year-to-date 2022. And as all financial advisers know, poor financial market returns are a precursor for tough conversations / reviews with clients. Are you confident that the funds you recommend for your clients will deliver returns through the economic and financial market cycles? Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts editor@fanews.co.za.