Sandy Nairn: The secrets of true value investing
Merryn Somerset Webb Sep 20, 2012
When I went to meet Sandy Nairn last week my mind was full of Burberry – its slowdown in sales and what it tells us about Chinese growth (nothing good, obviously). So I ask Sandy if he thinks that the sell-off in luxury goods stocks in the aftermath of the Burberry statement might tell us that global investors are beginning to get it on China. If it is, he says, it’s about time. Anyone who actually thought that China could grow at a compound real rate of 8%-9% indefinitely “clearly can’t do arithmetic”.
Most investment mistakes come from the “linear extrapolation of secular trends”. The views of the China bulls are just another example of this. When people are convinced by something, they tend to seek out evidence that “supports their existing view rather than looking for evidence to the contrary”.
So in this case people took the ongoing growth in China even after the financial crisis and attributed it not to the fact that if you chuck enough stimulus into an economy you can create endless temporary GDP growth, but to the superiority of the Chinese model. That’s a mistake.
How does he see the slowdown progressing from here? It’s an inevitable part of the shift from developing world to developed, he says. One of the myths of Chinese development is that productivity can keep rising at speed. But it can’t. Productivity rises very fast when a population is urbanising. But as soon as that slows – and it has to – and your factories are similar to those in already developed areas, it gets more difficult. In many cases the latter actually starts to have an advantage, as its “embedded infrastructure is probably stronger”.
The next stage then for China – as for all countries developing like this – is a shift towards increased consumption. It is hard to predict how this happens, but the key is that “it can’t not happen”. If you have real wages rising at 12% a year (as is the case in China), consumption has to rise.
But there is a flip side to this. Rising wages are gouging profit margins and at some point the exchange rate is going to move as well. That means that “the prices of products we have been used to seeing fall every year are going to start to rise”. That means that we in the West are “a lot poorer than we think we are”.
Speaking of countries that are poorer than they think they are (and of China) moves us on to Japan, where we both pursued our careers some decades ago, and which might just be rather better off than most people think it is. Nairn, as his new book makes clear (see below), is a great fan of John Templeton’s investment methods (value, value, value… ). So I ask him if Templeton would buy Japan today.
“Absolutely he would. I have no doubt he would.” It is cheap on all valuation levels from cyclically adjusted p/e ratios (CAPE) to price-to-book (p/b). At the same time, the starting point to investing in any market should be to ask if you can find good individual companies. And in Japan, “yes you can”.
There are plenty of good, internationally competitive companies, with cash on their balance sheets. Overall Nairn’s global portfolios are about 20% in Japan, something that hasn’t been great for performance (long-term MoneyWeek readers will know how this feels). But, as he says, it is all about “patience”.
Where else might there be value for the patient, I ask (I’m assuming most MoneyWeek readers fall into this category). Nairn thinks it easier to ask where there’s no value. OK, I say, where is there no value at all? That turns out to be easy. “There is definitely no value in government bonds.” What’s more, everyone knows that.
So is this a classic example of investors thinking they are clever enough to get out before the music stops? “Yes.” This, says Nairn, has been one of “the longest booms in history”. Bond prices have been rising for 25 years and that, says Nairn, may well have been one of the drivers behind our credit bubble.
As prices rose year after year and any scepticism around the bull market disappeared, it began to make sense for bond investors to leverage their portfolios. After all, if “bonds make you money and bond derivatives make you more money”, why wouldn’t you leverage up? The answer, of course, is because “they won’t when this stops”.
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But the crash when it comes will be no different to the many we have seen before. Nairn has a fantastic collection of books on crashes from the 1800s on (there has been no shortage of bubbles or crashes for those interested in this sort of thing). And the difference between the crashes of 200 years ago and those today? The books on the older ones are “much better written”.
How does the end come for the bond boom? With just a little bit of inflation. Nairn (rather like Dr Peter Warburton, who I have written about before) thinks that, due to constantly deferred capital expenditure, there is actually very little spare capacity in the global economy. That makes real deflation very unlikely, but a little bit of inflation likely.
And with bond prices where they are, you don’t need much to cause “turmoil” in bond markets. Prices only have to fall a little (or yields to rise a little in response to inflation) for people to see that bonds don’t guarantee capital protection – and to start selling them.
What of inflation and equity markets? There is a very clear relationship between the CAPE and inflation, says Nairn. As long as inflation is between “0% and 4%, maybe 5%”, CAPE can be anything. But push inflation above that and the CAPE will fall. So if we expect inflation of over 4%, we need to buy markets that are already on a low CAPE. So “we can buy most of Europe and we can buy Japan”. But we can’t buy many other Asian markets and we can’t buy America.
I wonder what he thinks about the market’s current mania for dividend which can tell us nothing good about growth stocks.“They’ve done very well and that’s fine.” But investors have a tendency to “mistake predictability for safety”. That’s not the same thing. Safety actually lies in valuations. Cheap is safe. Expensive is not safe. Right now, “segment the market by variation of valuation growth” into five sections, and you will find that the quintile with the lowest variation of earnings growth (ie, the one that makes investors feel most secure) is “the most expensive it has ever been relative to the rest of the universe by some distance”.
This situation might last a while, but nonetheless the valuation now means it makes sense to slip away from the consensus and to start to buy cheaper stocks with “less predictability” from the remaining 80% of the market.
I ask more about Templeton. He was clearly a phenomenal investor. But look at his method and you will see that it is one most fund managers say they follow (but don’t appear to). Everyone knows that proper value investing works over the long term, so how is it that so few people make a real success of it?
Sir John didn’t have any “behavioural biases”, says Nairn, and it was that absence of bias that really made him such a genius investor. He was just disciplined enough to follow his rules.
And Nairn? He anchors himself in data. He has taken all the rules of thumb used by Templeton and tested them properly. That means he has all the empirical evidence to hand, something that “has taken away the doubt”. Most investors, on the other hand, he suspects, “think they can be just a bit cleverer than the value rules – they can buy an expensive momentum stock of some kind and they’ll know how to get out in time”. But that practically never happens – which is why most managers fail in the end.
I wonder then if the key characteristic for being a good value investor is having a high capacity for boredom? Surely the reason most so-called value managers end up rushing out to buy the Facebooks of the world is because buying cheap things and waiting for them to go up can be an excruciatingly dull business? Nairn thinks not.
Portfolio management should take up a very small amount of a manager’s time. And how should the rest of it be spent? In open-minded thinking. “I don’t have much turnover but I haven’t got enough minutes in the day to do what I want to do and think about things I want to think about… I go home thinking about stuff. John Templeton was never bored.” And neither is Nairn.
Who is Sandy Nairn?
After gaining a PhD in economics from the University of Strathcyde in 1985, Dr Sandy Nairn’s first job was as an economist at the Scottish Development Agency. That was followed by stints as a researcher and then portfolio manager at fund group Murray Johnstone. In 1990 he moved to Templeton Investment Management, where he oversaw global equity research for a decade.
In 2000 he left Templeton to help turn around Scottish Widows Investment Partnership (SWIP), Lloyds TSB’s struggling Edinburgh-based investment business. As chief investment officer he helped lift SWIP’s performance, dragging it into the first quartile of performance from the fourth in less than two years. He also found the time to publish a book on technology investing in 2001.
By 2003 he was ready for a new challenge. He quit SWIP and set up a new boutique fund-management business called Edinburgh Partners, with several of his former colleagues. There he researches the telecommunications sector and manages several portfolios.
He has also recently co-authored a new book with journalist and investor Jonathan Davis. Called Templeton’s Way With Money: Strategies and Philosophy of a Legendary Investor, the book studies the investment methods of Sir John Templeton on the 100th anniversary of his birth.
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