Serious Money

January 30, 2009 5:58 pm

Black swans come home to roost

Investors in so-called “value stocks” have had a lot to put up with in the past year. Company finance directors cutting – or suspending – their dividends. Equity analysts insisting that share prices were at too wide a discount to net asset values, only for those assets to be written down – or written off. Fund managers buying into historically low price/earnings ratios, just as the history books – and the earnings estimates – were being ripped up.

But, arguably, their ultimate nemeses have been black swans.

Not the literally rare birds now found in the wild in the Devon town of Dawlish – although news that the Environment Agency is threatening to relocate the entire eyrar (the correct collective noun) may well be ruffling the feathers of the avian and investing communities of Henley-on-Thames, home to the Queen’s mute swans and Invesco Perpetual’s legendary value stockpicker Neil Woodford.

Rather, the metaphorical birds that have become shorthand for any improbable and entirely unpredicted phenomenon – ever since sightings of black swans in Australia by Dutch explorer Willem de Vlamingh astounded northern hemisphere twitchers in 1697 (up until when the Oxford English Dictionary listed “a whiting” as the collective noun).

John Stuart Mill first used the waterfowl to demonstrate the fallacy of drawing conclusions from a series of apparently consistent data. As he put it: “No amount of observations of white swans can allow the inference that all swans are white… the observation of a single black swan is sufficient to refute that conclusion.”

Nassim Nicholas Taleb has more recently cited the birds as a reason for distrusting analysts’ financial forecasts and dismissing fund managers’ performance. Or as he puts it: “Go ask your portfolio manager for his definition of ‘risk’, and odds are that he will supply you with a measure that excludes the possibility of the Black Swan – hence one that has no better predictive value than astrology.”

Nevertheless, some fund managers are starting to acknowledge the effect of black swan interventions on value investing strategies.

Nick Sheridan, manager of the New Star European Value Fund, believes buying value stocks is “common sense… by not overpaying for a stock, an investor increases the chance that the security can generate a higher return.” But in a paper earlier this month, he conceded that “clearly, in a period that has seen many of the proverbial black swans, there is still an element of risk in betting against growth [stocks] outperforming.”

That risk has been palpable of late. In 2008, the MSCI UK Value Index fell by 32.2 per cent – more than the FTSE 100 and more than the 23.2 per cent fall in the MSCI UK Growth Index.

To Sheridan, if this phenomenon continues, it will contradict all previous observations. “One aspect of the equity market that has historically repeated itself is the outperformance of value over growth stocks.” He even cites research by Morgan Stanley showing that valuation factors are now dispersed at more than two standard deviations from their historical mean – in other words, prices, earnings and book values now look highly improbable, if not impossible.

However, Robert Jukes, strategist at Collins Stewart Wealth Management, believes he may have the proverbial swans by the neck. He argues the underperformance of value stocks is both predictable and avoidable – it’s just that investors, like 17th century ornithologists, have been looking in the wrong place. “The problem with buying value stocks today is the increased exposure to cyclical earnings risk,” he argued last week. So, with corporate earnings now in question, the price-to-book value ratio is a more reliable indicator than price/earnings. “Not all valuation measures behave the same. One reason for dominance of price-to-book may be the absence of earnings in the valuation ratio – the likely weak link in many valuation metrics.”

Disconcertingly, though, there is now a veritable flock of stocks displaying a low price-to-book ratio. DigitalLook reports that 27 FTSE 100 companies currently trade at a discount to their liquidation value.

Jukes suggests that price volatility has muddied the waters. “Value stocks tend to underperform as market-
implied volatility rises and to outperform as volatility falls.” So with volatility now falling, screening for value should start to work again.

Even Neil Woodford at Invesco Perpetual now sees “tremendous opportunities ... many high-quality businesses are trading at extremely depressed valuations”. But then the only swans he can see from his office window are white.

matthew.vincent@ft.com

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