Terry Smith on Bubbles & Crashes

Sir John Templeton, who founded the eponymous investment management group, once said, ‘The four most dangerous words in investing are: This time it’s different’. He was pointing out that there are always people who are willing to rationalise outbursts of investment mania but they are always proven wrong when the bubble bursts and investment fundamentals reassert themselves. We have seen this before, not only in the Dotcom boom and bust, but in other examples such as the Japanese market in the late 1980s. Then we were told that the PE of over 50 on the Nikkei Index was OK because Japanese accounting was conservative. In fact the market was just over-valued. After the subsequent fall in the Nikkei it took until 2024 for the index to regain the peak it attained in 1989. When companies and/or investors are encouraged by soaring share prices and valuations to believe that capital is almost free, some disastrous investment decisions follow. They seem to act as though the cost of the capital that companies are investing is to some degree the reciprocal of their PE ratio. So, a PE of 50 equates to a cost of capital of 2% (100÷50). This is utter nonsense. The cost of equity does not vary inversely with the valuation and is perhaps best estimated by the cost of so-called risk-free capital, being the yield on long-dated government bonds plus what is called an equity risk premium.

Perhaps the executives running some of the leading AI companies have a clear view of the future and can foresee that AI will produce not just a transformation in our lives and the way we work but also incremental cash flows such that the returns on the humongous amounts of capital they are investing will be adequate or better than adequate. But if not, we can expect Sir John Templeton’s adage to be proven to be right once again, albeit maybe after a longer period and larger scale of irrational exuberance than we have seen in the past, driven by the momentum of index investing. However, even if we are right in diagnosing this move to index funds as one of the causes of our recent underperformance and it is laying the foundations of a major investment disaster, I have no clue how or when it will end except to say badly. With sincere respect to the late Sir John Templeton whom I quoted earlier, I think this time it may be different. Not in the sense that the Magnificent Seven/AI boom is different but rather in the scale it may attain and how long it may persist. When we had the Dotcom boom the proportion of AUM which was in index funds was under 10%. The dominance of index funds now makes the rise of these large stocks a self-fulfilling prophecy. 3. Dollar weakness Just to add to the headwinds, the US dollar fell against the pound from about $1.25/GBP at the start of the year to $1.35 at year end: USD vs GBP Exchange Rate Source: Bloomberg

to risk free as you can get) of close to 5%, why take the risk of investing in equities? The short answer is because equities provide a better return. For the period 1928–2023 (the earliest for which I can get reliable data), the annualised return on 10 Year US Treasury Bonds was 4.6% whereas the S&P 500 compounded at 9.8% with dividends reinvested#. This of course includes the Great Depression and World War Two as well as other more recent and lesser incidents like the 1987 Crash, the Dotcom meltdown, the Great Financial Crisis of 2008–09 and the Covid pandemic. This is unsurprising. Equities benefit from a feature which no other asset class, including bonds, can provide: a portion of the profit or cash flow which belongs to the shareholders is reinvested each year by the company. This is the retained profit which is not paid out as dividends, and its investment is the source of compounding which underpins the returns of long-term investment. In my view this is the least discussed and appreciated aspect of equity investment versus all other asset classes. So, if equities outperform bonds why are investors so keen to hold bonds at the moment? The answer of course is that whilst equities may outperform bonds over long periods of time, there is no guarantee that equities will provide this superior return in any given period, and in fact they may lose value for periods of time, as they did in 2022.cartoon:

We saw this in Japan in the late 1980s in a bull market when the Emperor’s garden was valued more than the state of California and the Tokyo Stock Exchange was on a P/E of about 100. The aftermath has been prolonged and worsened by a penchant for not admitting failure. So-called zombie companies that should have been allowed to fail have been propped up with continued funding and allowed to survive. Sending good money after bad is never a recipe for success. However, before we leap to the conclusion that this is in any way a uniquely Japanese trait let us bear in mind that other than Lehman no other major company was allowed to go bust in 2008, despite it being the largest financial crisis for 75 years. Japan’s bubble was followed by the Dotcom era in which money could be raised for an idea. The resulting meltdown was painful and especially for investors who had bought a business plan rather than a business. It is worth bearing in mind that real businesses survived and prospered. Amazon’s stock declined by about 95% during the Dotcom bust. It has since risen about 600 fold to its peak.like

We provide our own version of this total cost including dealing costs, which we have termed the Total Cost of Investment (‘TCI’). For the T Class Accumulation shares in 2020 this amounted to a TCI of 1.01%, including all costs of dealing for flows into and out of the Fund, not just our voluntary dealing. We are pleased that our TCI is just 0.04% (4 basis points) above our OCF when transaction costs are taken into account. However, we would again caution against becoming obsessed with charges to such an extent that you lose focus on the performance of funds. It is worth pointing out that the performance of our Fund tabled at the beginning of this letter is after charging all fees which should surely be the main focus. Some commentators have attributed our recent outperformance to the performance of technology stocks accompanied by warnings that a ‘bubble’ is building in technology stocks rather like the Dotcom Bubble and that it may burst with similar ill effects. The technology heavy NASDAQ Index has provided a total return of +40.9% in 2020 and the MSCI World Information Technology Index delivered +40.2% so maybe they have a point.as

Of course, all this may prove is that everything is expensive or at least highly rated, and there are plenty of pundits and fund managers who have indeed suggested that we are in a so-called ‘bubble’ which will end badly with everything falling a long way. So far, they have only managed to demonstrate the difficulty in making predictions and implementing actions based upon them. Even if they are eventually proven right, why will a basket of cyclical stocks and financials prove to perform better in these circumstances than a group of companies which are high quality and defensive in terms of supplying everyday consumables and necessities? The events of 2007–09 suggest that the opposite is true.