More and more of you seem to be following Warren Buffett’s (pictured) advice to invest in companies with strong “economic moats” – sources of monopoly power that allow earnings to grow by fending off competition. Such a strategy has worked well in the past. But it carries a danger.
This is simply that it is possible by now that so many investors have woken up to the past success of investing in moats that such stocks are now overpriced, or might soon become so. For example, Reckitt Benckiser, Unilever and Diageo – big stocks with powerful brands – are now all on below-average yields despite operating in mature markets. And in the US, Amazon is on a PE ratio of a whopping 250.
In other words, moat stocks carry wising-up risk. They might now be so highly priced because investors have wised up to their historic merits and so future returns will be poor.
Certainly, there’s a precedent for this. In the 1980s investors realised that small stocks had outperformed big ones for decades. So they piled into them. In doing so, however, they drove their prices up too far, which led to a decade of huge underperformance; in the 10 years after October 1988 the FTSE Small Cap index underperformed the FTSE 100 by 56 percentage points. And the ratio of the Small Cap index to FTSE 100 has never returned to its late 1980s peaks.
That wasn’t an isolated example. Jeffrey Pontiff at Boston College and David McLean at Georgetown University have shown that stock market mispricings largely disappear after researchers have pointed them out. John Cotter and Niall McGeever at University College Dublin have recently shown that the same is true in the UK – although, oddly, it seems not to be the case in other stock markets.
Wising-up risk is an especial danger because the same big price rises that suggest a strategy has been successful in the past might also be evidence that investors have cottoned on to it, perhaps even to the extent that they’ve jumped onto a bandwagon and pushed prices up too far, as they did with small stocks in the 1980s. In this sense, the evidence in favour of a strategy is also evidence against it.
Worse still, wising-up risk should in theory be the sort of risk that doesn’t bring with it extra returns. It’s easy to spread the risk that (say) monopoly-type shares are overpriced simply by buying other stocks. Basic economic theory says that if a risk is so easily diversifiable it should not carry a risk premium.
In his excellent book, Finance for Normal People, Meir Statman at Santa Clara University says investors often commit a framing error. They think of trading as being a race against the market. In fact, though, it’s a race against other people, many of whom might be fitter, better trained and faster than us. This means that before we embark on any strategy that’s worked in the past we must ask: what is stopping other clever people from doing this? What reason do we have to think that these stocks are still underpriced?
A good answer here sometimes is: risk. Defensive stocks, for example, have been consistently underpriced because some fund managers have avoided them for fear they will underperform if the market rises sharply. And cyclical stocks such as housebuilders have done well on average because some investors avoid them for fear they will crash in a recession.
More arguably, momentum stocks might also fall into this category. Victoria Dobrynskaya at the National Research University in Moscow says that they have the wrong sort of beta: they underperform both when the market falls a lot and when it rises a lot. To compensate for this, they must do well in more normal times.
Also, it’s possible that momentum stocks carry growth rate risk. The idea here is that a share’s price will often rise a lot if its growth options improve – if, for example, a resources company sees a big rise in the value of its potential reserves. To exploit such options, though, the company must invest and expand. But there are dangers in doing this: investment projects can run over time and over budget; they can distract managers from other tasks such as controlling costs; or they can lead to high debt; and so on. Some reasonable investors might avoid momentum stocks for such reasons. That will mean they deliver good returns to braver investors if the risks don’t materialise. But those returns will only be a reward for taking on risk.
But here’s my problem. I can’t see why moat stocks carry risks such as these, except insofar as they are ordinary defensive stocks. Some of you might think this lack of especial risk is a reason to buy them. I’m not so sure. When investors believe that an asset is safe, it’s often a sign it is overpriced. Investors must therefore approach moat stocks with caution.
