Rules of engagement

You can roll your eyes at the gimmickry of a St Valentine’s themed article, but unless you’ve never made a bad choice on an investment or committed errors in portfolio management, chances are the parallels between our financial and personal lives won’t be lost. Of course, the two are intertwined – marriage and divorce are among the biggest and costliest events in life – but that aside, affairs of the heart provide perfect metaphors for many of the greatest challenges and lessons of investing.

Life rewards calculated risk-takers

Most new investors and even experienced individuals don’t properly understand risk, which is all about ups and downs and doesn’t always equate to loss. Individual companies can go bust but if you have a well-diversified portfolio, you’re very unlikely to get wiped out in a downturn. On that basis, you’ll only lose money when forced to sell holdings as downside risk is materialising.

Risk is best thought of as uncertainty, which is reflected in how the prices of assets change, and that cuts both ways. The fact is, over time, risk has been skewed to the upside. Take shares for example. Between 1900 and the end of 2019, despite spells where stock markets have fallen by as much as half, the average annual return for global shares has been 5.2 per cent after inflation, according to Credit Suisse research.

Contrast that with permanently sitting on the sidelines and not investing – by letting inflation eat away savings you are almost guaranteed to be worse off. Ensuring the value of your savings grows faster than prices rise is the reason why investing is an essential life choice.

Pursuing romantic relationships involves similar trade-offs: you may get knockbacks asking people out, argue with a partner or experience painful break-ups. The only sure way to avoid this distress is to remain single. But, to be wistfully poetic, loneliness is to the soul as inflation is to cash.

Stay in the game but understand the pitfalls

The cognitive dissonances that lead to mistakes in love can have their echoes in many a bad investment decision. Seeking instant gratification is an evolutionary consequence of the brain’s pleasure centre (the nucleus accumbus) taking the wheel from our thinking zone (the medial prefrontal cortex) when we were faced with on-the-spot life-or-death choices as hunter-gatherers.

Gamification of investing via apps such as Robinhood triggers the same prehistoric impulses and can lead to harmful behaviour. Dating apps have been similarly accused and it’s not too much of a stretch to come up with an analogy for over-trading. Dopamine hits are one thing, making yourself steadily wealthier or happier over the long haul is another matter.

We need look no further than the recent GameStop (US:GME) controversy for an example of retail investors landing on the wrong side of pump and dump behaviour. Whipsaw movements in the price of silver on the back of more Reddit forum speculation will have dealt painful lessons to many.

Buy-and-hold investors aren’t immune to poor choices either, especially if they are seduced by the up-front promise of a fat dividend cheque. It’s great when a company pays out, but sometimes high yields can be the sign of a basket case and investors must be alert for red flags.

Gaps in financial fundamentals should set alarm bells ringing. Are the dividends covered by profits and more importantly are other obligations like interest on debt met first? In other words, are dividends being paid out of a company’s free cash flow and as another check, how does the cash a company generates from its operations compare as a percentage of its accounting profit? Shares that look solid on these measures and are able to increase profits over time, can keep investors happy with a progressive dividend policy.

Thanks to the hit company earnings have taken in the coronavirus lockdown recessions, income from shares has been slashed. When the recovery eventually takes hold, boards will be keen to reinstate pay-outs, but the speed and sustainability of dividend growth will need to be assessed with prudence.

But I’ve changed… beware value traps

Yields are an indicator of value, too, but this investment style has been out of vogue for over a decade.

The idea that out of favour companies might have seen their shares overpunished - and could therefore be prime for a re-rating – served investors well between 1950 and 2000, but simple applications of value investing have failed badly since the turn of the millennium. Sometimes, other investors have dumped companies with very good reason, so you shouldn’t take a chance on them either.

With a few important caveats, there are value-led strategies that have worked, as last week's round-up of Simon Thompson's 2020 Bargain Shares picks shows. Over the years, Simon’s market-beating portfolios have seen some very substantial gains. These are down to diligent use of the value principles uncovered by The Intelligent Investor author Benjamin Graham, such as uncovering companies with a margin of safety baked in the form of balance sheet cash that backs up a hefty chunk of a company’s market valuation. Crucially, there is also often a catalyst for other assets to become more productive and generate greater future returns than are priced in.

More generally, the value malaise can be explained by a lack of such catalysts and too much focus on the ratio of a company's share prices to its book value per share (P/B). Expecting share prices to suddenly shoot up because the company owns a mine or a factory it values at a given amount in its accounts is a fallacy. Some companies, like some relationships, only add up on paper. 

As the world economy has been transformed by digitalisation, businesses with comparatively few fixed tangible assets have led the way. If old economy companies don’t put their buildings or plant to good use, those assets are more likely to be impaired and on such bad news shares only get cheaper.

Furthermore, as governments and economies look to rebuild after the coronavirus pandemic, tremendous emphasis is being placed on sustainability and reducing carbon emissions. Meaningful moves to reduce dependence on fossil fuels is encouraging divestment from oil and gas companies, which is a secular decline rather than a mere valuation blip.

Weaker long-term demand coincides with higher cost of capital for firms; environmental, social and governance (ESG) scores penalise polluters, so it costs more to raise finance. Together, these factors make projects less viable, so there will be cases when assets – such as undeveloped oil fields – must be written down.

What’s your hot earnings to crazy valuation threshold?

On the other side of the green transition, many investors have enthusiastically swung behind narratives on electric vehicles, renewable power, and hydrogen fuel cells. It goes to show getting swept up in a story isn’t only a romantic characteristic.

When you buy a growth stock, the call is the company will continue to build its profitability and cash flows. Companies can be valued on high multiples of forward earnings because investors believe business performance will continue to force analysts to upgrade their forecasts. Some companies are now on crazy valuations, which means their earnings growth and momentum (and the momentum of forecast upgrades) must be red hot to justify the investment.

To be sure you’re not just relying on blind optimism – a human trait evident in divorce rates after couples wrongly assumed they could remain ‘happily ever after’ – you want to find companies that maintain or expand the economic rent they yield. In other words, transformative businesses that are dominating the markets they sell into.

Economic rent can be expressed simply as the free cash a company generates as a percentage of its economic assets. As markets mature and competition intensifies, the selling prices of products falls and economic rent fades. At this point only normal levels of profit are being made and investors shouldn’t pay huge multiples of cash flows for shares.

Giants such as Microsoft (US:MSFT), Apple (US:AAPL), Alphabet (US:GOOGL) and Amazon (US:AMZN) continue to delay the fade and make good on the confidence shown in them. They keep the spark in their relationship with investors by retaining that capacity to surprise to the upside on earnings.

Don’t get hung up on your ex investments, judge new opportunities on their merits

The valuation of electric vehicle trailblazer Tesla (US:TSLA) has done most to raise eyebrows and  commentators who remember the dotcom bubble worry investors may get their hearts broken all over again. While it is always wise to take lessons from history, however, anchoring expectations to what happened in the past can lead us to make fresh mistakes or miss opportunities.

Using the economic rent ‘hot-to-crazy’ ratio is useful because it shows whether companies are heading towards proving the bulls right. Typically, as growth momentum slows, economic rent fades towards a company’s cost of capital. In other words, the cash flows generated for shareholders cease to outstrip the costs to the business of funding projects by raising finance from debt and equity markets.

Amazon is perhaps the best example of a business that has ‘beaten the fade’ by continuing to maintain its economic rent over a number of years. The company’s ability to continually leverage its asset base has led to what Pascal Constantini, partner at research firm ValuAnalysis, has dubbed Amazon’s anti-fade model.

There are more unknowns at a business such as Tesla, but ValuAnalysis report, The Price of Growth, highlights its potential to progress economic rent. Tesla has only just started to turn a profit but that still marks it as being very different to many of the dotcom stocks, some of which scarcely had revenues, let alone positive earnings momentum. 

Sometimes, it all comes down to taking each new opportunity – whether investing or in other aspects of life – as they arise. With regards to businesses, the 1979 five forces model of Harvard professor Michael Porter, is still worth remembering. 

If a company like Tesla is to make good on its promise to keep expanding its economic rent, how will the bargaining power of suppliers and buyers pressure its margins? What other substitute technologies might emerge? What is the threat posed by new entrants to its markets and how well will existing competitors meet the electric vehicle challenge?

Competition may well prove the most troublesome force for Tesla. Analysts at German research firm Block-Builders note, for example, that Volkswagen may be able to sell as many electric vehicles as Tesla by 2025. Pointing to the seven-fold rise in Tesla stock last year versus less than 11 per cent for Volkswagen, Block-Builders analyst Raphael Lulay suggests that “in light of this disparity, the scale of Tesla’s valuation is particularly questionable”.

Que sera, sera

Apart from analysts, sage mother-like advice on relationships is worth remembering when selecting companies to invest in. Not getting saddled with a bum who has too much debt for one. Building back from Covid-19, many companies have much more bloated balance sheets thanks to the sources of funding raised to keep them going through the pandemic.

Strong balance sheets will be highly prized as signs of quality going forward. But quality without growth in shares is like meeting a good-looking, wealthy partner and then finding you have nothing in common that adds depth to your relationship.

Remember, debt is only a problem if it can’t be serviced. So long as the debt pile (and therefore the obligation to pay interest) is managed prudently, pension liabilities aren’t onerous, and capital expenditure plans are well set out and covered, companies with growing revenues will throw off more free cash. With interest rates low, a certain amount of debt is a sign of an efficient balance sheet for a growing company.

Know when to call it quits

Getting tied down with the wrong investment can be figurative or literal. Open-ended property funds and some of the illiquid investments at the heart of the Neil Woodford scandal demonstrate times it can be hard to physically sell.

This is a risk that can be mitigated by using closed ended investment companies to access asset classes like real estate, small cap companies and private equity holdings. More importantly, such holdings should be relatively light as part of your asset allocation, so you can ride out spells when liquidity dries up in underlying markets.

Petrification of the mind is the investor’s enemy, too. Loss aversion is often the culprit, as individuals cling to losing holdings in the forlorn hope they will come back and break even. Inevitably we are also afflicted by the endowment effect – focusing solely on information about investments we own and ignoring wider updates that could help achieve better returns.

Being aware of when to call it quits may seem like countermanding the advice to buy and hold for the long-term. Perhaps a more sensible approach is to apply the mantra of staying invested to your asset allocation and conduct regular (but not overly frequent) health checks on your holdings. Investors should retain exposure to asset classes but if better in-class funds exist it could be time to switch.

For individual shares, you could audit the underlying financial strength of companies at regular intervals. Also, keep an eye on economic rent fading, if the magic is gone then it’s best to move on.

Being honest with yourself is the starting point to happiness

Deciding your investment strategy requires self-reflection and honesty. If volatile investments aren’t right for your personality, and your ambition doesn’t require especially high returns, then don’t take the risk.

Circumstances like your age, health, home ownership status, hobbies, travel plans, how much you earn, your career prospects, and whether you have or want children should be considered. Values are important, too, especially if you believe in sustainable investing. Apart from questions about your height, it’s very much like creating an online dating profile.

Know your type – go after the right portfolio asset allocation

Choosing the right asset allocation (the weights in your portfolio assigned to shares, bonds, cash, property, and alternative investments) will set you on the path towards financial objectives. This should be done to get the most bang for the downside risk you’re willing to accept.

Conservative types can skew towards less volatile investments but stay in the game and beat inflation by retaining some exposure to investments like shares that spice up their portfolios. More adventurous people can temper their wild side with strategic positions that dilute some risk – diversification is the safe word for portfolios.

Making investments fit your asset allocation and investing style is also personal, but you should keep in mind what you’re looking for, both immediately and in the long term. Of course, if you have time and inclination, there is no harm in having a bit of fun. Racier investments can be an exciting wild ride but be sure of what you’re getting into and don’t sacrifice a stable future.