James Montier: The three cardinal rules of investing
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Jody Clarke Nov 13, 2009
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Jody Clarke talks to James Montier, value investor, behavioural finance expert and Guns N Roses fan.
What potential threats face the market?
The biggest threat is probably inflation. Lots of people are saying there's a lot of slack in economies, so we have huge output gaps [the difference between an economy's actual output and what it's capable of when running at full capacity], which will keep prices down.
But at the end of the Great Depression, the output gap in the US was huge, 30% of GDP. Yet they went from a strongly deflationary environment to 4%-5%-plus inflation inside 12 months. So investors are underestimating the ability of inflation to ignore output gaps when you have a monetary response similar to the one we've had from the Federal Reserve. And this is the great worry.
How do investors protect themselves?
One way is to buy gold, although that's appreciated since I began writing about it in October last year, when nobody wanted to know. Now everyone has an opinion, which makes me slightly nervous. I certainly wouldn't call it cheap insurance anymore. But I think it has a part in a portfolio as an insurance asset.
One other form of protection is dividend swaps, because they've been enormously mispriced to my mind. They are pricing in incredibly low growth in dividends, so they offer a cheap source of inflation protection. They're tricky for the average person on the street to get hold of, but you can trade them on the futures exchange, or through IG Index.
Is the equity rally overdone? I was exceedingly bullish at the end of last year and through the beginning of this year. But the scale of the rally has strip-mined a lot of the value out of these markets. They're not cheap, but not exceedingly expensive – they're in the boring fair-value range. So I don't think there are many opportunities right now.
Patience is the best strategy, which is itself quite tricky because people always want to do something. This is where private investors have an advantage over the professionals – they don't have a benchmark to constrain where and how they can invest. So they can sit and do nothing, they can hold cash, or be fully invested. It's entirely up to them.
What other qualities do successful investors need?
A healthy degree of scepticism and the ability to take an independent view. When you look at the best fund managers – and there are some exceedingly good ones – they don't rely on stockbroker research or recommendations from investment bank analysts. They do their own research – people like my new boss, Jeremy Grantham, or Seth Klarman, probably one of the all-time legendary fund managers. In Britain, you have guys like Neil Woodford. All these people are seriously independent-minded thinkers.
You're a value investor – how do you go about finding a 'value' stock?
There are three things you need to look at. One is the valuation. Is this stock cheap? If so, it's a potential investment. If not, forget about it there and then. The second is what its balance sheet looks like. That answers the question, 'is this stock cheap for a reason?', ie, is it a value trap? In the good times, nobody cares about the balance sheet. But it's incredibly important because you can't really analyse earnings without understanding the balance sheet behind those earnings. Yet very little effort goes into checking them. The third question I ask is what the management is doing with the capital I give them. What are they going to do with my cash? Spend it on pet projects, or on something worthwhile? Those three things really provide investors with everything they should be looking at.
Nothing else investors need to know?
No. Wall Street would have you believe that you need to know everything about everything before you make an investment. But in fact, to make an investment, what I need to know is relatively limited. I simply don't need to know everything about everything. There's a classic belief that it's necessarily better to have more information.
The problem is that this ignores the fact that the human brain is a limited processing device. We are not a crazed supercomputer that can handle bytes and bytes of information simultaneously. What happens is that too much information confuses us. We can't concentrate on it. So what we actually find is that the more information you give investors, the worse their decisions tend to be.
Underachiever who predicted the crash
An "ageing rock fan", James Montier grew up in Sussex, where he wasn't a promising student. "I was probably too busy listening to Guns N Roses and mucking around", he says. One school report read: "Sets himself low standards, fails to achieve them." Yet he went on to excel in economics, doing a Masters degree in the subject before joining Dresdner Kleinwort in 1992.
Montier specialises in behavioural finance, which looks at how our psychology affects our investing; and value investing, which is the topic of his latest book, Value Investing: Tools and Techniques for Intelligent Investment.
At Société Générale, with colleague Albert Edwards, he predicted the crash, but also told investors to start buying value stocks, not long before the market bottomed in March. He left Société Générale earlier this year to join US asset manager GMO.
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