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Short-term, stories, herding and what have we done in our portfolio

We live in a world where we expect results right now. We want same-day package delivery, faster Internet speeds and coffee ready for pickup before we even get to the café. Instant gratification has become an obsession.

Unsurprisingly, this short-term focus also translates to the world of investing. The individuals responsible for managing our hard-earned savings and the money we need to last through your retirement years are often being judged on a short-term basis. You don’t rush a winemaker during the maturation process, you don’t rush an engineer building a bridge and you certainly don’t rush a surgeon performing open-heart surgery. All of these professionals need time to do their job right. Investors like Sir John Templeton, Walter Schloss, Charlie Munger and Warren Buffett underperformed the S&P 500 Index around 30% of the time.

The vast majority of market participants think of stocks as pieces of paper to be traded, not an entitlement or claim to the underlying earnings of a business. These investors take their cues about their investment decisions and the company they’ve bought from short-term stock price movement rather than the performance and outlook of the underlying business.

As such, a stock price decline must imply the outlook is deteriorating, and vice versa. But stock prices move for all sorts of reasons, and many of them are unrelated to business fundamentals. And humans are emotional, they often over-react; psychological biases mean they often do the wrong thing at the wrong time. Consequently, stock prices can have little semblance to what a company is worth, be it too high or too low. Basically, stock prices are frequently irrational.
This is the beauty and the real opportunity in the stock markets. These markets are brimming with emotional participants who don’t know what they own, what their stocks are worth and who buy and sell at the wrong times. Emotions rather that facts drive their investment decisions. Sometimes it’s not even people, but two algorithms programmed to sell at market prices, come what may. No price is the wrong price for an algorithm.

You have to have an attitude that divorces you from being influenced by the market as Warren Buffett once said. Look at the business as to how much it is and not at the stock price, because the stock price doesn’t mean a thing. Over the longer term a company’s share price must reflect the value of the future earnings of that company.

Stories sell. We often believe them without thinking or questioning. And they can have an unjustified weight on our perceptions. Consequently, stories often impact markets and our investment decisions when they shouldn’t. I’m sure you’ve seen a situation where an analyst or journalist writes a short story about a stock or sector. Then the market takes it as a given and the stock or sector plunges as a result.

Why do we believe such stories? Why do we get hooked into these narratives that are neither factually correct or accurate? The answer is, we are wired that way; mankind actually hasn’t evolved much from the days we spent hunting and gathering. One of the key skills that allowed us to progress from these primitive beginnings and reach the top of the food chain was collaboration. And collaboration involved stories. Yuval Noah Harari made the point in his book Sapiens: “We are the only mammals that can cooperate with numerous strangers because only we can invent fictional stories, spread them around, and convince millions of others to believe in them.”

Overcoming the pull of stories requires keeping an open mind, collecting all the facts and testing investment ideas. Before acting on stories and narratives it’s important to test their validity. This must be done by collecting more information.
Human beings are herd animals. We survive in coordinated groups and align our behaviour with those around us. Many investors seek the perceived safety of the crowd, jumping on the bandwagon when a certain stock or sector is in favour and jumping off when sentiment turns negative. That’s how market bubbles grow and burst. Collective greed drives prices higher just as collective fear does the opposite.

Albert Einstein once said: ““Insanity is doing the same thing over and over again and expecting different results.” You can’t do the same things others do and expect to outperform.

So what have we done recently in our portfolio?

• Think differently: Value Investing often leads you to look for opportunities where you least “feel like” going. These opportunities today are in cyclical sectors such as automobiles or basic materials and in geographical areas such as emerging markets and Europe. Also where political instability is high, such as in the UK due to Brexit. We went there to look for them.

• Think long term and not short term: Following the sharp falls in the second half of 2018, we saw the opportunity to lay the foundations for higher returns in the future, as the opportunity arose to buy very good business that we had on our radar, at very attractive prices in “uncomfortable” places.

• Don’t believe the “story”: The recent tension in the trade dispute between the US and China, which has intensified especially after the sanctions imposed on Huawei, affected the prices of the companies in our portfolio, not their fundamentals.

• Do our homework and rely on the facts: as companies released their results, we reviewed all our investment theses to ensure that they remain valid.

All these decisions, keeping our portfolio hedge at 60-65%, lead us from having a portfolio valued at 12x P/E to a current one below 10x, with a dividend yield above 4% and, more importantly, with an 11% potential annualised return to a current one of 15%. The difference in these five points of additional potential return is that, if we invest 10,000 euros today and in five years we get 10% a year, we would have 16,105 euros (+61%), while if the return is 15%, we would get 20,114 (+101%) or 40% more.

When you plant a tree, you give it time to grow while the sun and rain nourish it. You don’t keep digging up the sapling to check its roots, and you don’t panic in the winter when the leaves fall because it’s just part of the natural cycle. The same applies to investing. You give your portfolio the time it needs to grow and benefit you in the long-term, and you don’t panic when growth stalls temporarily versus an index. A long-term perspective brings peace of mind and enhances the power of compounding your investment.

Sincerely,
Key Capital OCHO
Investment team

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