By David Larrabee CFA
Noted behavioralist and value investor James Montier, a member of money manager GMO's asset allocation team, recently participated in the European Investing Summit, an online conference hosted by ValueConferences. He addressed the prospect of investing in European stocks through the framework of his Seven Immutable Laws of Investing. These are common sense, value-based principles that are too often violated by the typical investor. Although Montier suggests that there are pockets of value in Europe, he still sees considerable risks - just the type of environment that demands a disciplined investment approach.
Here's a quick recap of how Montier applied his laws of investing to Europe:
Always insist on a margin of safety. Montier emphasized the importance of making an accurate valuation assessment. He does this by breaking down returns into their component parts: Valuation (using a normalized P/E ratio), profit margins, sales growth, and dividend yield. Considering the prospective contributions of each of these elements, Montier thinks eurozone investors are being offered "a pretty reasonable margin of safety." A return to normalcy, he predicts, will deliver "7% to 8% in real terms per annum for the next seven years."
This time is never different. Famed investor Sir John Templeton considered "this time is different" to be the four most dangerous words in investing. Montier noted that crises like the one unfolding in Europe generally get worse before they get better. But, with a hint of optimism, he also pointed out that in early 2009, the U.S. market sell-off was overdone due to excessive pessimism and that "the pendulum had swung too far." He does not yet see the same level of despair in Europe, nor the same number of bargains in European stocks - caused by an "overcapitalization of fear" - suggesting that equity valuations have room to fall further.
Be patient and wait for the fat pitch. Montier believes that "the very protracted nature of this crisis means that one doesn't dash in. The market valuations are not quite fat pitch level," he said, referencing a baseball metaphor. He finds leverage to currently be highly correlated with value in Europe. The time to buy, according to Montier, will be when the market indiscriminately sells down both high-quality stocks and "junk." Once investors do buy in, Montier counseled, they must be prepared to hold on for the long term.
Be contrarian. Montier pointed out that one should not be a contrarian purely for the sake of it, and he is not convinced that it pays to have a contrarian viewpoint at the moment. Noting the valuations accorded highly leveraged firms in the telecommunications and utilities sectors, he suggests that risk is not being sufficiently compensated for in all cases. Montier thinks investors should avoid the Scandinavian countries, which have benefited from a flight to safety, and look to the periphery of Europe, including Italy and Spain, for value. He advised investors to apply some form of cyclically adjusted valuation as their primary filter and then consider how that measure will change going forward.
Risk is the permanent loss of capital, never a number. Just as he had earlier this year, with his keynote address at the CFA Institute 65th Annual Conference in Chicago, Montier criticized classical financial theory that equates risk with volatility. Volatility, he argued, is a value investor's friend because it creates opportunity. On the other hand, risk is the potential for the permanent impairment of capital, and that can come from buying expensive assets, miscalculating intrinsic value, or being forced to prematurely exit a position. While Montier currently thinks valuation risk is limited in Europe, the macro uncertainties give him pause.
Be wary of leverage. Leverage, according to Montier, "is one of the easiest ways of destroying capital." He pointed to banks as being particularly vulnerable, saying, "You have this towering mass of assets of unknown quality resting on this tiny sliver of shareholder equity." Invoking Graham and Dodd's Security Analysis, Montier called balance sheet analysis "absolutely vital to any process that claims to be a value-based approach," and he bemoaned the fact that too many self-described value investors pay little attention to the balance sheet. Drawing a distinction between utilities and financials, Montier said the stability of a firm's cash flows is a critically important consideration. Combining unstable cash flows with leverage, he said, is a "recipe for serious disaster."
Never invest in something you don't understand. When it comes to Europe, Montier emphasized the futility of trying to understand all the competing political forces at play and how they will impact the markets. Recalling that Elroy Dimson, the London Business School emeritus professor of finance, defines risk as "more things can happen than will happen," Montier noted that the range of outcomes in Europe is extreme. Nevertheless, the GMO strategist referred back to his first law, saying that a sufficient margin of safety should compensate for the"unknown unknowns."