James Montier (of GMO, author of Value Investing: Tools and Techniques for Intelligent Investment) was at the European Investment Conference recently, where he argued against the idea that mean reversion was dead. This isn’t the first time that he’s made the argument, a few months ago on his blog, he said:
In a recent article Richard Clarida and Mohamed El-Erian of PIMCO argued that the ‘New Normal’ offered at least five implications for portfolio management.
I. Investing based on mean reversion will be less compelling
II. Risk on/risk off fluctuations in sentiment will continue
III. Tail hedging becomes more important
IV. Historical benchmarks and correlations will be challenged
V. Less credit will be available to sustain leverage and high valuations
Implications IV and V seem pretty reasonable to me. However, reports of the death of mean reversion are premature. I fear that the authors are confusing the distribution of economic outcomes with the distribution of asset market returns. The distribution of economic outcomes may well turn out to be flatter, with fatter tails than we have previously experienced.
However, asset markets have long suffered such a distribution; it has proved no impediment to mean reversion based strategies. In fact, the fat tails of the asset market have provided the best opportunities for mean reversion strategies. For instance, in equity markets the fat tails associated with unpleasant outcomes (poor returns) have generally occurred as high (sometimes ludicrously high) valuations have returned towards their ‘normal’ level, and the fat tails which we all love (good returns) have occurred as low valuations have moved back towards more ‘normal’ levels.
Reports Of The Death Of Mean Reversion Are Premature (Behavioural Investing)
Anne-Louise Fogtmann has a good take down of what Montier said at the conference. Montier outlined his own views which I thought were interesting, particularly on cash:
Seven “immutable laws of investing” apply, Montier argued, as they have in the past:
-Always insist on a margin of safety.
-This time is never different.
-Be patient and wait for the fat pitch.
-Risk is the permanent loss of capital, never a number.
-Be leery of leverage.
-Never invest in something you don’t understand.
With these rules in mind, Montier noted, somewhat bleakly, that “not very many assets have any margin of safety.” A few of his specific calls: Government bonds have no return potential; emerging markets look overvalued; and in a world where both bonds and equities could be too expensive, cash becomes a much more attractive investment, even when the yield is near zero. Not only is cash a better inflation hedge than bonds (it’s a zero duration asset), it can act as a store of value during periods of deflation.
GMO’s James Montier Says Rumors of the Death of Mean Reversion Are Greatly Exaggerated
The market’s had a pretty good run lately, making most equities more expensive for value investors. The dynamic between cash and equities is a really interesting one for us because we tend to hold portfolios that are more concentrated. Other investors might have the kind of allocations which allow them to replicate the movements of your typical indicies, but value guys tend to take a 5% to 10% position approach. This makes our allocation decision a bit more difficult. There’s a big difference between re-creating an index versus putting on 10% positions in full value/expensive stocks. This is why, for concentrated investors, it makes sense to shift to cash rather than equities. At the same time, there are pockets of value scattered throughout the market. While no one sector seems to offer compelling valuations, I have been spending most of my time analyzing select companies in industries ranging from energy to insurance.
Montier’s point about emerging markets being expensive is one that resonates with me. Take the case of Brazilian banks Bradesco (NYSE:BBD) and Itau (NYSE:ITUB). Both are priced richly at over 4x book value, but are generating high returns on equity (32% and 40%) implying an 8-10% return. If we dive deeper into the financials and analyst estimates, we can see that much of this is being driven on the prospect of loan growth. Brazil has a rapidly growing middle class and most people expect that financial services firms will be able to profit from that growth.
I agree that a developing middle class should be able to help the banks. In theory, as the banking sector in Brazil becomes more formalized, citizens should be depositing more money into banks and using them for payment transfers. That should lower the cost of funding for Brazilian banks. Plus, Bradesco and Itau are targeting for insurance income to make up 25% of their earnings in a few years. These are truly financial services supermarkets and I could see that part of the equation working out. But analysts are modeling loan growth at rates of 30% annually. I just don’t know if Brazil can sustain such growth levels. You could make the argument that much of the growth could be going to consumers, not commercial enterprises, but to me that kind of lending is much more difficult. At least when a bank loans to a business, the credit analysts can give a business a good scrubbing and have the business’ assets used as collateral. Consumer lending is an entirely different beast. They could try to increase the amount of mortgages on their books, but the problem there is consumer demand might not match up with supply, you might end up creating a mini-housing bubble.
To me, emerging markets at this point have a lot of things going for them. I do expect the BRIC countries to do well over the long term. But as a value investor I just don’t think you will get the margin of safety that you are looking for. Everything has to go right for them to warrant such high valuations. Buying right now is akin to being a trend follower or momentum investor. I have a list of great companies in BRIC countries that I usually check every other day. The way I figure it, given the way the global economy is going — any heightened level of volatility might trigger a pull back and make some of these companies a bargain. For now, you might be better off analyzing large caps with emerging market growth exposure. Those businesses still seem to be trading at attractive valuations.