A Message from Alex Fowler

You may have heard by now that we are in a "bear market", meaning many share markets around the world have fallen 20% from their heights at the start of the year.

While a bear market is perceived by many to be a different era of sorts, the truth is share markets keep operating in the exact same way as during the preceding bull run. Investors are continually evaluating what a company's shares are worth, pricing in new information. Depending on if this information is positive or negative, markets will go up or down.

We can't predict what the market will do tomorrow, next week or next year. We can be sure that they will deliver over the long-term.

However, we appreciate that emotions run high during these rougher periods. This is why we wanted to share a message from our own Alex Fowler. Alex has written the following short message covering his own experience with historic downturns while providing advice to clients.

---

A Career of Highs and Lows
By Alex Fowler

After more than 30 years in the financial advice industry, I would like to believe my reputation is of an outspoken proponent for the interests of clients. I hold strong feelings about how to best serve clients and I have not been afraid to share these feelings with others, as the advice I gave was based upon decades of scientific evidence. But with so much data available today, I cannot ignore the role “strong feelings” play in the world of investing.

If you spend enough time doing something, you can see the world changing around you. I started providing financial advice a year before the 1987 crash, a downturn so bloody that many New Zealand shares investors packed their bags and never returned. A terrible shame, as those who stuck around were well rewarded. Following this crash, I watched NZ’s financial advice industry shift from a “wild west” to the more sensible, regulated system we see today. Markets recovered, though many names disappeared during the recovery.

A decade later came the dotcom bubble. The rise of the internet was something with no historical precedent. Much hyped new tech companies boomed, until a colossal crash in the early 2000s brought market prices back two years. With the internet being such a new development, many investors couldn’t make heads or tails of what was going to happen to the stock market as a whole. Some of these new-fangled tech companies survived through this bust to become mainstays, such as Amazon and Ebay. Many more disappeared, yet share markets trundled along.

Next was the GFC, when rampant betting on the US housing market seemed to threaten toppling the global economy. Markets fell for a long time. Fears were running high again. As with the other crashes, through which I had advised my clients to sit tight, there was no precedent for what we were experiencing. Yet I knew how markets rewarded the steadfastness of long-term investors. I knew the research proved that these strong feelings would hurt investors if they acted upon them. My advice was always to stay in your seat and wait it out.

As markets came back stronger through the many ups and downs of my career, who would’ve guessed the next test of discipline would come from a global pandemic? What we saw in 2020 was a remarkably quick drop in prices. Even more remarkable was how quickly they shot back up! All of this amidst an underlying nervousness where people were stacking up toilet paper in their foyers!

I have seen many articles talking about our “post-covid world”. I can’t dismiss the notion that the world has changed again somewhat, yet the important things have not changed at all. People will still pursue successful careers, time spent with their families, fulfilling retirements. Investing is still crucial in achieving these goals.

Many of you reading this were clients of mine during the GFC, some from much earlier. I hope you feel my advice helped you achieve some of the goals in your life so far.

Every downturn during my career has come with commentators crying out how, on these new untrodden paths, anything could happen. That each downturn comes from it’s own unique circumstances is an obvious truth. But from my experience, nothing has changed in the way markets work since I started giving advice back in 1986 (or in the many decades prior). We go through tough periods occasionally, then things come back. The research which has guided my advice has held true all these years. Markets reward disciplined investors.

It is natural to feel disconcerted when the value of investments fall. We must recognise these strong feelings are rarely helpful in making good investment decisions. Markets are working in the same way they did 30 odd years ago and investor’s are feeling the same anxieties as in previous crashes. The advice I have to give is the same advice I was giving all along. Don’t let strong feelings get in the way of your investment success.

Value Outperforms as Growth Stocks Come Back to Earth

I was pleasantly surprised last week, not just because I was reminded of the upcoming long weekend, but also because I saw the following headline in the Herald.

I was surprised as the article started off talking about value investing. The p/e ratio (price vs earnings) is one way investors distinguish between value stocks and growth stocks. For the sake of simplicity, value stocks are "cheap" stocks and growth stocks are "expensive".

The difference in performance between cheap value stocks and more pricey growth stocks is well documented. Eugene Fama and Ken French developed their 3-factor model back in the early 90s, proving value to be the most significant factor in estimating how a stock will perform relative to it's peers. Their model explained more than 90% of long-term performance with only 3 variables.

Yet these factors are seldom discussed in the media. It is refreshing to see this topic brought up, though not surprisingly, this follows a start to the year where value stocks have done far better than growth stocks.

How much better? Well we know the S&P 500 index, representing the 500 biggest companies in the states, is down about 15% for the year to date. Here is the performance of the S&P 500 Growth Index, which is focused on only growth stocks.

And here is the performance of the S&P 500 Value Index.

What a difference! It seems the largest value companies in the US have outperformed the largest growth companies by 17% since the start of the year!

And yet the performance of the S&P 500 is closer to the growth index than the value index. This is because the biggest companies tend to be quite expensive "blue-chip" companies. At the start of this year, the big tech stocks represented about 30% of the overall index. While these, and other growth stocks, have been performing poorly, the index has been dragged down with them.

I mentioned above that growth companies can be considered "expensive", and value stocks "cheap". One key metric used to judge value vs growth is the price-to-earnings ratio. Put simply, how much am I paying for a company's share compared to how much that company is bringing in?

All else aside, a higher p/e ratio means a more expensive stock. Fama and French's research showed these higher ratios are correlated with poorer performance and vice versa.

Consider the FAANG stocks; Facebook (now Meta), Apple, Amazon, Netflix and Google (now Alphabet). At the start of the year, these all qualified as growth stocks. An average stock in the S&P 500 has a p/e ratio of 16 currently. Here are the p/e ratios of the FAANG stocks at the end of 2021:

• Facebook - 24

• Apple - 29

• Amazon - 66(!)

• Netflix - 54

• Google - 26

All of these companies were considerably more expensive than the average US stock. Netflix and Amazon shares were more than three times more expensive than the average when adjusting for earnings.

I mentioned growth stocks have led the overall market's charge downwards, and these FAANG stocks are certainly no exception. Facebook is down more than 40% year to date, with a new p/e of 16. Netflix is down a whopping 66%, with a new p/e of 18. Funnily enough, following these drops, the p/e ratios of these shares now looks a lot like the average market! Amazon is down 29%. Alphabet and Apple are nearing 20% down.

This disparity between two halves of the market puts this year's poor performance in a new light. The relatively cheaper stocks have fallen slightly over the past five months while the expensive growth stocks have dropped considerably. It is only reasonable to suggest this is simply a market-wide repricing of these stocks, whose prices have soared over the past few years.

Now, this is not to say they were over-priced at the start of the year. Markets are very efficient at pricing in information, including both the figures on balance sheets and more intangible risks. Investors are willing to pay high prices if they expect these companies to grow their earnings significantly in the future.

However, sometimes those intangible risks don't pay in your favour. Facebook announced this year they had lost users for the first time since their creation. Suddenly investors had to reevaluate the company's potential for earnings growth and so the share price fell.

More broadly speaking, central banks around the world have announced plans to hike interest rates to combat inflation. Coupled with supply chain issues and other rising costs, investors have reconsidered how much these expensive companies can increase earnings in a less rosy environment. Many companies have also announced lower earnings expectations this year. The drop in prices for the year to date reflects these developments.

The morale of the story - markets are working well to price in new information. The drop in prices we've seen so far is a normal reaction to this information.

Performance for the year to date is more due to sky-high expectations coming down to Earth than a collapse of markets. The stark difference between growth stocks and value stocks shows this.

Moving forward, we can't predict whether markets will go up or down, that depends on whether we get good news or bad news next. That isn't up to us to decide. As always, it's best to stay calm and focus on what we can control instead.

About the lousy year start

Let's be honest, the start of this year hasn't been great for investors. Both share markets and bond markets are down, inflation is back and uncertainty seems here to stay.

However, it may not be so grim as it seems. While we would love it if markets climbed every day like clockwork, we know it doesn't work like that. Periods where markets fall are normal, as investors adjust to new information and uncertainty.

I understand times like this can be unnerving, so I thought I would briefly discuss what is happening in markets and why we should stay the course moving forward.

What's spooking the markets?

The two big factors affecting broad markets have been inflation and interest rates. Inflation has taken hold across the globe, with most central banks indicating sharp rate hikes are on the way to control prices.

Bond markets reacted quickly to this new information, with prices falling in response to the announcements. Because newly issued bonds will generally provide higher returns in the future, bonds already held by investors are less appealing, hence the drop in prices.

With share markets, on the other hand, the effects can be harder to predict. In general, higher interest rates make raising capital more expensive for businesses and inflation can lead to increases in costs.

But share markets are complex and are comprised of many different company's stocks. For the year to date, high oil prices have benefitted energy companies considerably, while transportation costs negatively affect others. Banks and financial institutions also typically benefit from rising interest rates, as part of their incomes are derived from interest payments.

Pricing in uncertainty

In addition to inflation and interest changes, the war in Ukraine continues to create uncertainty, along with oil prices and supply chain issues.

Markets hate uncertainty, so this additional risk leads to a fall in share prices and volatility in the market, with prices quickly jumping up and down. Investors are effectively asking for a discount to compensate for the risk of the unknown.

When uncertainty is resolved, share markets can rebound quickly. We saw this in early 2020 when Covid-19 was spreading at an accelerating pace. Most markets fell by 30% or more in a single month.

Once government responses were organised and our understanding of the virus developed, markets bounced back remarkably quickly. The S&P 500 regained half of lost ground in teh following month and was at new highs by August, even while economies were still adjusting to the shock.

While we cannot guarantee such recoveries moving forward, it is important to note how uncertainty affects markets. When new information arrives, markets will quickly adjust to reach new, fair prices.

The return of value

While markets are down, value stocks have outperformed growth stocks by a wide margin for the year to date.

Growth stocks are those which have high share prices relative to their assets. Investors choose these companies as they believe earnings will grow in the future, justifying a high price now. In recent years, technology stocks stand out the most, with many having incredibly high valuations compared to their earnings.

On the other hand, value companies have low share prices relative to their assets, indicating investors see some risk in investing in the company. Consider airlines during the early stages of the pandemic. Their shares were heavily discounted due to the loss of income, but also the uncertainty regarding their futures.

Decades of academic research show that investors are rewarded for taking on value over growth. While growth stocks have done well lately, over longer time periods, value comes out on top.

For the year to date, growth stocks have been hit particularly hard. Tech stocks such as Netflix and Facebook have made the news due to their share prices dropping. With changing earnings expectations, it seems investors who paid a high price, banking on continued growth, have drastically reevaluated the value of these stocks.

In the US, IT and consumer discretionary have been among the worse performing sectors for the year. Overall, these sectors are comprised of mainly growth stocks. Energy and Materials have been among the best performing and are comprised of mainly value stocks.

The result is, as of today, the S&P 500 Index is down more than 10% since the start of the year. The S&P 500 Value Index is only down 2.5%. In Australia, the ASX 300 fell about 2% to the end of April. Dimensional's Australian Value Trust was up 8.8% over the same period.

Our investment strategies are built around pursuing value stocks, in addition to small company stocks and profitability. This recent comeback by value has buoyed our portfolios relative to the market for the year to date.

Four months is still short-term

In my last email, I mentioned recency bias, which causes investors to place more importance on recent events than those prior. When markets fall, we instinctually believe they will fall further. When we read bad news, we expect bad things will happen in the market. This can distract us from the long-term perspective needed to make good investment decisions.

With alarm bells going off regarding where markets are this year, it is easy to miss the S&P 500 is up more than 3% compared to this time last year. Over the past 5 years it is up about 80%, or roughly 12.4% each year, despite recent volatility.

Four months is a very short amount of time when we're talking shares. A fall of 10% is well within our expectations for this period. Remember how markets dropped around 30% in 2020, as discussed above.

Over 5 years, a 12% return is close to average, yet share returns could still be nil over this time, or higher than 20% p.a. Both outcomes are unlikely, but have happened before.

So how long is "long-term"? We agree with Sensible Investing's figure of 15 years or longer. Over this period, we can be reasonably confident our shares will deliver the returns we need to achieve our goals. We can also be reasonably confident value stocks will have outperformed growth stocks.

When investments are evaluated over a decade and a half, a few months make a small bump in the road. Although these bumps are pretty rough as we go over them, remember they are a small part of a long-term strategy.

Focus on what we can control

Nobody knows where the market is headed tomorrow, or the next month, or the next year. Over the next 20 years, we are confident it will be up a lot.

While no-one can predictably beat the market by timing when to buy and sell, or picking only winners, the good news is we don't have to. Time in the market rewards patient investors.

Ignore what we can't control. We can't affect what is happening with interest rates, inflation, oil prices etc. We can decide how we plan for the future, how we implement these plans, how we build our portfolios.

During times of volatility, when markets are up and down constantly, we rebalance portfolios to make sure they are aligned with our clients goals. When needed, we discuss with clients whether ups and downs affect their ability to reach their goals.

When it comes to predicting the future, we can leave that to sage's and oracles.